New rules announced for alternative mutual funds in Canada

A new regulatory regime that will enable fund managers to use alternative strategies in funds offered to retail investors is set to come into force in Canada in early 2019.

Under the new rules, a new category of mutual funds, known as “alternative mutual funds," are permitted to be offered to retail investors through a short-form prospectus. Alternative mutual funds can use strategies unavailable to conventional mutual funds, such as borrowing cash for leverage, short-selling beyond the limited restrictions that apply to mutual funds, and significantly investing in physical commodities and specified derivatives.

With this expanded marketplace for alternative investments, market participants, including fund managers, investment advisors, and regulators are taking action to raise awareness and provide insights on the technical elements associated with the new regime.

A recent seminar hosted by RBC Investor & Treasury Services (RBC I&TS) in November 2018 was designed to help Canadian fund managers prepare. Panelists included Carol Derk, Partner and Ron Kosonic, Partner at Borden Ladner Gervais LLP, and Vesna Dragic, Director, Prime Brokerage, RBC Dominion Securities.

New Final Rules modify existing regulatory regime

The changes to the regulations that introduce alternative mutual funds are the product of a multi-year effort on the part of the Canadian Securities Administrators (CSA) to update and modernize the rules governing Canadian investment funds, and give retail investors access to the alternative investment sector.

Alternative mutual funds
can use strategies unavailable to conventional mutual funds

The new regime was first outlined by the CSA and consulted on in March 2013. Based on the results of this initial consultation, in 2016, draft amendments to National Instrument 81-102, Investment Funds (NI 81-102), as well as related National Instruments, were published for comment. The Final Rules, published in October 2018, and coming into effect on January 3, 2019, incorporate adjustments to the draft amendments proposed in 2016.

The changes bring Canadian regulation in line with the alternative funds marketplaces in the European Union and the United States, which provide access to alternative mutual funds to retail investors through the UCITS (Undertakings for Collective Investment in Transferable Securities) framework, and the 1940 Act, respectively.

Six key differences for alternative mutual funds

At the November RBC I&TS seminar, Carol Derk and Ron Kosonic provided an overview of six key differences between conventional mutual funds and the new, prospectus-offered alternative mutual funds. These were:

• Leverage: Perhaps the most significant difference between alternative and conventional mutual funds is the ability of alternative mutual funds to use leverage, through derivatives, short-selling, and cash borrowing. The new rules set the aggregate limit on the use of leverage by an alternative mutual fund at 300 percent of the fund's Net Asset Value (NAV).
• Borrowing: Alternative mutual funds may borrow cash of up to 50 percent of NAV for investment purposes, subject to certain requirements (including that cash borrowing combined with short-selling cannot exceed 50 percent of NAV). Conventional mutual funds are only permitted to borrow on a temporary basis up to 5 percent of NAV to fund redemptions, or to settle portfolio transactions.
• Short-selling: Alternative mutual funds are permitted to engage in the short-selling of securities up to a limit of 50 percent of NAV, compared to 20 percent for conventional mutual funds, again subject to certain requirements (including that cash borrowing combined with short-selling cannot exceed 50 percent of NAV).
• Extensive use of derivatives: Alternative mutual funds are permitted to use specified derivatives for leverage or to create synthetic leverage (so they are not subject to any cover requirements), and are not subject to the requirement (as conventional mutual funds are) that the derivatives counterparties they deal with have a designated credit rating.
• Custody: Alternative funds are subject to the custody requirements of NI 81-102, meaning hedge fund managers that want to launch an alternative fund may have to change their custody arrangements in respect of that new fund.
• Disclosure documents: Alternative mutual funds are generally offered in the same manner as conventional mutual funds. For alternative funds not listed on a stock exchange, offering documents will include the preparation of a simplified prospectus and annual information form, as well as a Fund Facts document for each class or series of units of the fund that is delivered to investors at the point of sale. For exchange-traded funds (ETFs), disclosure requirements include a long-form prospectus and an ETF Facts document.

Together, these key differences “change the game" for players in the Canadian marketplace, commented Derk and Kosonic, “bringing together new opportunities for retail investors, fund managers, and other market participants".

Naming conventions for new alternative funds

The changes bring
Canadian regulation
in line with the alternative
funds marketplaces in the
European Union and the
United States

The Final Rules define an alternative mutual fund as “a mutual fund, other than a precious metals fund, that has adopted fundamental investment objectives that permit it to invest in physical commodities or specified derivatives, to borrow cash or engage in short selling in a manner not permitted for other mutual funds". (This definition updates the definition proposed in 2016 to specifically exclude precious metals funds, which now form a separate category of investment fund.)

The Final Rules do not set out a naming convention for these new funds, which are not required to contain the word “alternative" or other similar language in the fund name to indicate that the fund is an alternative mutual fund. However, the Companion Policy to NI 81-102 advises that in order to avoid potential confusion, publicly offered mutual funds should not use the word “alternative" in their name unless they qualify as an alternative mutual fund under the new rules.

These key differences “change
the game" for players in the
Canadian marketplace

The new rules use the phrase 'alternative mutual fund' in place of the 'liquid alternatives' (or 'liquid alts') terminology that had been used earlier in Canada and is common in other jurisdictions, such as the US.

Opportunities and challenges for all market participants

With the arrival of the new rules, market participants in the alternatives marketplace—from retail investors to investment dealers, fund managers, and regulators—will face a new regulatory regime with new opportunities.

This new regime, in turn, may require participants to alter operational models. For example, fund managers developing alternative funds may need to seek new services, including custody arrangements, to facilitate their expansion to retail alternative mutual funds.

Paul Stillabower, Managing Director and Global Head of Client Experience at RBC I&TS, notes that custody models will be required to evolve to develop prime custody services that support asset managers with plans to launch alternative mutual funds, including the legal framework to support such models. “As a global asset servicing provider, we have already had to review and address this type of challenge within the European landscape, specifically with the UCITS regime. We will combine our considerable experience in custody and settlement services with partners that can support trade execution and clearing to effectively, and seamlessly support Canadian managers as they look to take advantage of this emerging opportunity."