European investment funds in real estate and alternative assets are vulnerable and could face liquidity risks in the event of a sudden investor sell-off, according to a senior official at Europe’s main financial markets supervisor, the European Securities and Markets Authority, or Esma. “It is one of the tricky issues here,” he said.
Markets in these funds are experiencing “a structural imbalance” in terms of liquidity, with supervisors showing particular interest in potential liquidity problems that can emerge when investors withdraw from open-ended real estate funds, said Christian Winkler, team leader of the Investors and Markets section at Esma.
“There is this structural kind of imbalance between the liquidity on the asset side like for the investments, and which is low like if a firm wants to divest, it takes a long time. And then investors, they have a heavy kind of high liquidity,” Winkler said, speaking after the release of the latest Esma report on trends, risks and vulnerabilities.
“This is the thing to watch out for. Because if investors want to move out very quickly out of real estate funds, then the funds are in trouble.”
‘Blurry picture’
Winkler, speaking to journalists, described the vulnerabilities as “a supervisory issue”, in particular for open-ended real estate funds. A similar mismatch in terms of liquidity exists also at alternative investment funds. Managers of such funds need to manage these risks “pretty closely,” he said.
“There is a structural vulnerability behind real estate funds,” he said. “This is something that is being watched very closely. But also, if you look at alternative investment funds, our statistical report gives a pretty clear picture on how this kind of structural mismatch of liquidity between funds on the asset side and on the liability side, for the investors looks like. It is a bit of a blurry picture. So these funds are vulnerable. And kind of that risk needs to be managed pretty closely by them, and of course needs to be supervised by the regulators.”
In its latest risk report, known as its TRV Report, Esma said it continues to see the overall risk of current market conditions “at its highest level”. Contagion and operational risks are now considered very high, like liquidity and market risks, it said. Credit risk stays high but is now expected to rise. Risks remain very high in securities markets and for asset management, Esma said.
‘Prepare for further corrections’
“The Russian military aggression against Ukraine, its political and economic effects, and increased inflation profoundly affected the risk environment of EU financial markets,” the authority said. “Recoveries in EU financial markets faltered, volatility increased and market corrections grew more likely.”
Looking ahead, Esma said risks to infrastructures and to consumers both remain high, though now with a worsening outlook, while environmental risks remain elevated. “Going forward, the confluence of risk sources continues to provide a highly fragile market environment, and investors should be prepared for further market corrections.”
Against that backdrop, Winkler said real estate investors pose a particular concern.
“There’s this inherent risk. How it develops really depends on what type of view investors are taking. Whether they are thinking property prices start to fall, which everyone talks about, and that risk is real in a weak economy and with rising interest rates, and whether they take a short term view or a long term view. “It’s really about behaviour by investors. That is a tricky issue for the fund that they can find hard to manage, like outflow in a very short period of time.”
Investor behaviour seen as key
Compared to March 2020, when investors suddenly withdrew their positions from open ended funds at the start of the Covid-19 pandemic, Winkler noted that investments funds in Europe now have seen strong outflows over a long period of time. Industry body Efama on Thursday reported that Ucits and alternative funds in Europe experienced net outflows for a sixth consecutive month in June.
“Now we have strong outflows over a long period of time. This was okay to manage,” Winkler said. “Investor behaviour is key on that one. Do investors take a short term view and rush out? Or do they take a longer term view and may be able to bear losses over a period of time and wait for the recovery? This is also one of the tricky issues here.”