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Are alternative mutual funds gaining traction?

Canadian liquid alts at the one year mark

Early in 2019, Canada’s mutual fund landscape evolved with the introduction of a new regulatory regime enabling fund managers to use alternative strategies in funds offered to retail investors. Nearly one year on, the industry is taking stock.

At a recent webinar hosted by RBC Investor & Treasury Services, Carol Derk, Partner and Ron Kosonic, Partner at Borden Ladner Gervais LLP (BLG), discussed the current state of play, and considerations for asset managers looking to incorporate alternative mutual funds into their offerings.1

Key insights

  • Liquid alts funds provide retail investors with access to the benefits of alternative investments, in a flexible and liquid structure
  • The first year of this new regulatory regime has seen regulators provide some rule clarification, and exemptive relief where warranted, providing further guidance to the industry as it moves forward with liquid alts
  • Fund managers considering converting existing hedge funds to a liquid-alts structure need to determine whether their overall investment strategy can work within the rule constraints for liquid alts, including a review of whether investor approval might be required, and whether changes need to be made to material contracts

Alternative mutual funds’ distinguishing features

Under the revised rules, a new category of mutual funds, known as “alternative mutual funds” or “liquid alts”, may be offered to retail investors through a simplified prospectus.2 In contrast to conventional mutual funds, alternative mutual funds can use an expanded range of investment strategies, including borrowing cash for leverage, short-selling beyond the limited restrictions that apply to mutual funds, and significantly investing in physical commodities and specified derivatives. Alternative mutual funds include the following key features:3

  • Leverage: Alternative mutual funds are able to use leverage in three distinct ways—through derivatives, short-selling, and cash borrowing, up to 300 percent of the fund’s Net Asset Value (NAV). The 300 percent limit is measured by reviewing the aggregate value of cash borrowing, plus the aggregate market value of short-sold securities, plus the aggregate notional amount of derivatives that have not been entered into for hedging purposes
  • Borrowing: Alternative mutual funds may borrow cash, subject to a “hard cap” of 50 percent of NAV, for investment purposes. The borrowing terms should match standard commercial terms, in accordance with industry practice, and the lenders must be entities that would qualify as a custodian under National Instrument (NI) 81-102 (e.g., banks and trust companies in Canada, as well as certain affiliates).
  • Short-selling: Alternative mutual funds are permitted to engage in the short-selling of securities up to a limit of 50 percent of NAV, again subject to certain requirements (including that cash borrowing, combined with short-selling, cannot exceed a “hard cap” of 50 percent of NAV).
  • Derivatives: Alternative mutual funds are permitted to use specified derivatives for leverage or to create synthetic leverage (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.
  • Rehypothecation: Pursuant to NI 81-102, an alternative mutual fund is permitted to deliver collateral to its futures commission merchant, derivatives counterparty, lender or borrowing agent if certain conditions are met. One of the conditions is that the records of the persons holding the assets must show that the fund is the beneficial owner of the assets posted by it as collateral.

‘Seeking relief’ helps modify the rules

In reviewing the ways in which liquid alts differ from conventional mutual funds, BLG’s Ron Kosonic commented that, “Some of the important details in the new regulatory regime are relatively complicated. As a result, the initial year of implementation within the financial services industry has seen some regulatory modifications that better reflect industry practice.”

For example, Fidelity Investments (Fidelity) sought relief from the provisions affecting alternative mutual funds relating to the collateral limitations for short-selling and rehypothecation of collateral for cash borrowing. In respect of the short-selling rules, Fidelity (and others subsequently) requested and obtained relief from the collateral limitations imposed if the borrowing agent is not a custodian, or sub-custodian, under NI 81-102.

The initial year of implementation has seen some regulatory modifications that better reflect industry practice

Fidelity also sought relief from the custodial provisions of NI 81-102 requiring that the records of the persons holding the assets show that the fund is the beneficial owner of assets it has posted as collateral, in order to permit the rehypothecation of that collateral.

Of the two areas of relief, the latter proved to be more complex, as industry participants and legal counsel expressed a variety of views. Ultimately, the request was withdrawn after Ontario Securities Commission staff represented to Fidelity, and the industry as a whole, that NI 81-102 does not preclude rehypothecation, and clarified the meaning of “beneficial owner” for the purposes of the rule.

Other forms of relief have also been obtained. One that has proven popular with fixed income managers removes the hard cap on shorting government securities as long as all other restrictions are adhered to, permitting such liquid alts to hold short positions in government securities of up to 300 percent of the fund’s NAV.

Fund strategies continue to evolve

The session included a discussion of how the new rules might be incorporated into an asset manager’s overall strategy. Presenters suggested managers of existing hedge funds, who are considering converting their funds to alternative mutual funds, should determine how and whether their strategies can work within the rules imposed by NI 81-102 without requiring regulatory relief. They may also want to review whether investor approval might be required. “Traditional mutual fund managers and dealers alike see liquid alts as an opportunity to expand their product offerings,” noted Carol Derk.

One year in, the rules governing the implementation of alternative mutual funds continue to be clarified. As the range of liquid alt funds in Canada grows, retail investors will see greater opportunities to broaden their diversification, and to benefit from alternative investments offered in a flexible and liquid mutual funds structure.

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Sources

  1. RBC Investor & Treasury Services (November 2019) Webinar: Liquid Alts Year One Report Card
  2. RBC Investor & Treasury Services (December 2018) New Rules Announced for Alternative Mutual Funds in Canada
  3. Borden Ladner Gervais (November 6, 2019) Alternative Mutual Funds – One Year Highlights