Published June 16, 2025
30-second summary:
Funds using the absolute VaR approach, selected by ESMA for its analysis, represent 8% of UCITS funds, or around 730 billion euros. Some of these funds are similar to alternative funds (known as ” alt-UCITS “).
According to ESMA, alt-UCITS have an average gross leverage of close to 800% of their NAV, a level higher than that of hedge funds regulated under the AIFMD, with in some cases leverage authorized by the prospectus of up to 12,000%. This leverage is mainly generated by the extensive use of over-the-counter (OTC) derivatives such as interest-rate swaps, equity derivatives and options. A comparison of alt-UCITS using the absolute VaR approach with AIF hedge funds reveals risk profiles that are often more complex for the former.
ESMA believes that alt-UCITS carry several systemic risks:
- In times of stress, massive margin calls could force funds to sell their assets quickly, amplifying market volatility.
- A quarter of alt-UCITS have initial margin ratios in excess of 90% of available cash, increasing liquidity risk
- Many funds hold similar positions, exposing the entire segment to specific market shocks.
- High concentration on a few counterparties exposes the financial system to the risk of cascading contagion.
1. Risks in UCITS funds using the Absolute Value-at-Risk (Abs. VaR) approach
UCITS are one of the pillars of the European collective investment market. Designed primarily for private investors, they benefit from a strict regulatory framework designed to limit risk and guarantee portfolio diversification.
However, some UCITS make extensive use of derivatives via the so-called Absolute Value-at-Risk (VaR) approach.
This approach enables funds to estimate the maximum potential loss over a month with a 99% confidence level, and can be used by the fund manager as long as it is adapted to the financial instruments used and validly backtested. The absolute VaR approach thus allows an increase in market exposure, particularly in low-volatility environments.
Global risk measurement for UCITS: Commitment approach vs. VaR approach
Restrictions on borrowing and synthetic leverage are covered by CESR’s Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS, April 2010. These guidelines provide for two main methods of calculating global risk: the commitment approach and the VaR approach(see box). For UCITS using the commitment approach, leverage is limited to 110% of net asset value (NAV). For UCITS using the absolute VaR approach, the 99% 1-month (20-day) VaR cannot exceed 20% of the UCITS NAV. In other words, depending on the internal VaR model chosen, a UCITS should not lose more than 20% of its NAV over one month in 99% of cases.
Use of the absolute VaR approach by UCITS
At the end of April 2025, the European Securities and Markets Authority (ESMA) published its first analysis of UCITS funds using the absolute VaR approach to measure overall portfolio risk, exploring the use of this risk measurement method, its implications for leverage levels, and potential risks to financial stability. The analysis is based on a sample of funds using the absolute VaR approach, representing 8% of UCITS funds, or €731 billion in assets under management at the end of 2023. This approach is particularly popular with funds domiciled in Ireland and Luxembourg.
Funds using this method follow a variety of investment strategies, with a predominance of fixed-income funds (52%), mixed funds (26%), andalt-UCITS (14%). The latter adopt alternative strategies comparable to those of hedge funds, combining market-neutral, global macro or multi-strategy strategies, among others.
Leverage levels and associated risks
The study shows that some UCITS using the absolute VaR approach exhibit extremely high levels of leverage. In particular, alt-UCITS display a weighted average gross leverage close to 800% of their NAV, a level higher than that of traditional hedge funds (448%) regulated under the AIFMD (Alternative Investment Fund Directive). Some funds even declare in their prospectuses expected leverage levels of up to 12,000%. Leverage is mainly generated by the massive use of over-the-counter (OTC) derivatives such as interest-rate swaps, equity derivatives and options. In the context of absolute VaR, the volatility of a portfolio defines the level of synthetic exposure that can be used: lower volatility leads to lower VaR, allowing funds to increase their exposure through derivatives until the risk constraint is reached.
Comparison with regulated hedge funds
A comparison of alt-UCITS using the absolute VaR approach with AIF hedge funds reveals risk profiles that are often more complex for the former. According to ESMA, alt-UCITS have higher gross leverage, use more complex products and are more vulnerable to liquidity risks.
Exposure is also highly concentrated: five main counterparties account for 50% of the notional amount of derivatives, increasing the risk of contagion in the event of default by one of these entities. In addition, the portfolios present significant similarities, particularly in the equity swap markets, reinforcing the risk of synchronized forced sales.
Systemic risks identified
ESMA thus identifies several channels for the transmission of systemic risks associated with UCITS using the absolute VaR approach:
- Forced liquidation risk: In times of stress, massive margin calls could force funds to rapidly sell their assets, amplifying market volatility.
- Liquidity risks: A large number of funds have little liquidity in relation to the margins they need to provide for their derivative positions. A quarter of alt-UCITS have initial margin ratios in excess of 90% of available cash.
- Excessive interconnection: High concentration on a few counterparties exposes the financial system to the risk of cascading contagion.
- Portfolio similarity risk: Many funds hold similar positions, exposing the entire segment to specific market shocks.
Technical review : Commitment approach vs. VaR approach
Under the commitment approach, UCITS are required to convert all their derivative positions into the market value of an equivalent position in the underlying asset. UCITS must also include exposure obtained through repurchase agreements or securities lending. For each offsetting and hedging transaction, UCITS calculate the net exposure. The overall risk according to the commitment approach is equal to the sum of :
- the absolute values of derivatives not subject to netting or hedging,
- the absolute value of each net commitment after offsetting and hedging,
- the absolute value of the commitment related to efficient portfolio management techniques.
For UCITS using the commitment approach, leverage is limited to 110% of NAV, including exposures financed by temporary borrowings (up to 10% of NAV).
With regard to the VaR approach, the CESR guidelines specify that the UCITS must use the VaR approach if :
- engages in complex investment strategies
- it has significant exposure to exotic derivatives
- or the commitment approach does not adequately capture the portfolio’s market risk.
A UCITS may use either a Relative VaR or an Absolute VaR approach. In the case of the Absolute VaR approach, the 1-month (20-day) 99% VaR cannot exceed 20% of the UCITS NAV. In other words, depending on the internal VaR model chosen, a UCITS should not lose more than 20% of its NAV over one month in 99% of cases.
