On October 4, 2018, the Canadian securities administrators published the final version of the amendments that will create a new regime for liquid alternative mutual funds (alt funds).
The regime will come into effect on January 3, 2019 and could provide retail investors with greater access to alternative investment strategies, including leveraged and market neutral portfolios.
Key to the regime is the ability of alt funds to use leverage. The leverage limit is effectively set at 4X the alt fund’s net asset value (NAV) and can be achieved through a combination of derivatives (alt funds are not required to hold cover for their derivatives), short selling (alt funds do not need to set aside cash cover for their short sales, and can reinvest their short sale proceeds in additional long positions) and borrowing. There will be a cap set at 50% of NAV for the aggregate amount of exposure through short sales and borrowing, with a further cap of 10% per issuer sold short (other than government securities). These caps are somewhat arbitrary within the overall 4X leverage limit, but are based on the investment restrictions the securities regulators saw in the closed-end fund space. Accordingly, 130/30 funds and other levered funds can be launched as alt funds, but the 50% cap on short sales means that a market neutral fund using a pairs trading strategy will need exemptive relief.
Interestingly, the final amendments include a new feature allowing alt funds to enter into derivatives with counterparties who do not have a designated rating.
The concentration limits will be raised for alt funds to 20% of NAV in any single issuer making it possible to launch, for example, a fixed portfolio fund concentrated in as few as five names.
Alt funds will be unrestricted in the types of commodities and amount of commodity exposure they provide.
Alt funds also will have accommodations on some operational requirements including:
- Alt funds may require 2 business days’ notice of redemption and may pay redemption proceeds up to 15 business days later.
- Alt funds may suspend redemptions for the first 6 months of operation.
- Alt funds may be charged performance fees based solely on a high-water mark (e.g. no need to outperform an index).
Similarities to conventional mutual funds
Alt funds will be a subset of conventional mutual funds. This means that, except to the extent they are given special treatment as described above, alt funds otherwise must follow the same rules as conventional mutual funds. These include:
- 10% limit on illiquid assets.
- Investments in mortgages are limited to 10% of NAV and all mortgages must be Canadian government guaranteed.
- Restrictions on lending activities.
- Custodian requirements.
- Fund-on-fund investing is limited to underlying funds that are public investment funds in Canada and index participation units (IPUs), but investments in other Canadian alt funds and closed-end funds will be permitted.
- Daily NAV calculations and daily processing of purchase and redemption orders.
Alt funds, if not listed, will be sold using a simplified prospectus and fund facts similar to conventional mutual funds except for certain additional prescribed disclosure. While multiple alt funds can be sold using a common simplified prospectus, alt funds and conventional mutual funds cannot be included in the same simplified prospectus.
Alt funds will need to provide a risk rating using the same standard deviation calculation applicable to conventional mutual funds and backfilled for ten years with the performance of a reference index (or blend of reference indices). The amendments include guidance to alt fund managers to consider additional criteria for possibly increasing the risk rating when the alt fund’s expected performance may not be synchronized with its reference index. It remains to be seen whether dealers will be comfortable relying solely on the risk rating provide by the alt fund manager.
New proficiency requirements for advisers selling alt funds were not developed in time to be included with these rules. As a result, the current proficiency requirements applicable to selling commodity pools will continue to apply for the foreseeable future, which will effectively limit the sale of alt funds to the IIROC distribution channel. IIROC dealers will need to roll out their internal requirements for approving alt funds for sale by their advisers, including any additional know-your-product (KYP) requirements.
Commodity pools will no longer exist in the regime. Existing commodity pools will become alt funds under the new rules and will be given a six month transition period to become compliant with the alt fund rules.
Something for conventional mutual funds
The amendments also include a few changes that should be beneficial for conventional mutual funds:
- The 10% limit on exposure to any single derivatives counterparty will be effectively eliminated, avoiding the need for longer-term swaps and forwards to be partially settled when their value approaches 10% of NAV.
- The prohibition against entering into a derivative with the mutual fund’s own securities as the underlying interest now is limited to taking the short position in such a derivative. This potentially enables ETFs to provide a derivative to their designated brokers as a better instrument to hedge the ETF’s securities held in inventory by the designated broker.
A variety of routine exemptive relief also is being codified including relief relating to:
- Investing up to 10% in commodities (other than gold), commodity pools (now alt funds) and closed-end funds.
- Investments in actively managed Canadian ETFs (effectively removing the requirement for underlying Canadian ETFs to be IPUs).
- Cleared swaps.
Impact on closed-end funds
The amendments also will make closed-end funds subject to generally the same investment restrictions as alt funds, including with respect to leverage and portfolio concentration. An exception is that the limit on illiquid assets will be set at 20% of NAV for closed-end funds (rather than 10%), with an obligation to reduce illiquid assets at 25% of NAV (rather than 15%).
With the investment strategies of closed-end funds now capable of being delivered through an alt fund, there may be little remaining market space for closed-end funds. Two possibilities are:
- Split corp structures (though single-name split corps no longer will be possible due to the new 20% concentration limit).
- Fixed term portfolios with little (or no redemption rights) prior to maturity.
Existing closed-end funds are grandfathered from these changes provided they do not make another public offering.
Fasken provides free seminars to managers and distributors of public and private investment funds on the opportunities and impact of these changes. Please feel free to contact us if you would like additional information.