National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions -- relief granted from alternative mutual fund short selling restrictions in NI 81-102, such that the aggregate market value of all securities sold short by a fund will not exceed 100% of the fund's net asset value, to permit alternative mutual funds each to short sell "index participation units", as defined in NI 81-102, of one or more investment funds the securities of which are index participation units, up to a maximum of 100% of the net asset value of the alternative mutual fund, subject to conditions -- relief from single issuer short selling restriction applies only to short sales of the index participation units of the investment fund issuer, not to the underlying portfolio holdings of the investment fund issuer of the index participation units.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds -- ss. 2.6.1, 2.6.2 and 19.1.
September 19, 2019
IN THE MATTER OF THE SECURITIES LEGISLATION OF ONTARIO (the Jurisdiction) AND IN THE MATTER OF THE PROCESS FOR EXEMPTIVE RELIEF APPLICATIONS IN MULTIPLE JURISDICTIONS AND IN THE MATTER OF 1832 ASSET MANAGEMENT L.P. (the Filer) AND IN THE MATTER OF THE FUNDS (as defined below)
The principal regulator in the Jurisdiction has received an application (the Application) from the Filer on behalf of the Funds for a decision under the securities legislation of the Jurisdiction of the principal regulator (the Legislation), pursuant to section 19.1 of National Instrument 81-102 Investment Funds (NI 81-102), exempting the Funds from the following short selling restrictions of NI 81-102 to permit each Fund to exceed these restrictions to short sell IPUs (as defined below) of one or more IPU Issuers (as defined below) up to a maximum of 100% of the Fund's NAV at the time of sale such that, immediately after entering into a transaction to short sell IPUs of IPU Issuers or borrow cash: (a) the aggregate market value of all securities sold short by the Fund does not exceed 100% of the Fund's net asset value (NAV); (b) the aggregate value of cash borrowing by the Fund does not exceed 50% of the Fund's NAV; and (c) the aggregate market value of securities sold short by the Fund combined with the aggregate value of cash borrowing by the Fund does not exceed 100% of the Fund's NAV (collectively, the Requested Relief):
(a) section 2.6.1(1)(c)(iv), which restricts a Fund from selling a security of an issuer, other than a "government security", as defined in NI 81-102, short if, at the time, the aggregate market value of the securities of that issuer sold short by the Fund exceeds 10% of the Fund's NAV (the Single Issuer Short Restriction);
(b) section 2.6.1(1)(c)(v), which restricts a Fund from selling a security short if, at the time, the aggregate market value of the securities sold short by the Fund exceeds 50% of the Fund's NAV; and
(c) section 2.6.2, which restricts a Fund from borrowing cash or selling securities short if, immediately after entering into a cash borrowing or short selling transaction, the aggregate value of cash borrowed combined with the aggregate market value of the securities sold short by the Fund (the Combined Aggregate Value) would exceed 50% of the Fund's NAV and which requires a Fund, if the Combined Aggregate Value exceeds 50% of the Fund's NAV, as quickly as commercially reasonable, to take all necessary steps to reduce the Combined Aggregate Value to 50% or less of the Fund's NAV (together with the restriction described in (b) above, the Aggregate Short Restrictions).
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):
(a) the Ontario Securities Commission is the principal regulator for the Application; and
(b) the Filer has provided notice that section 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in each of the provinces and territories of Canada other than Ontario (together with Ontario, the Jurisdictions).
Terms defined in National Instrument 14-101 Definitions, MI 11-102 and NI 81-102 have the same meaning if used in this decision, unless otherwise defined.
Aggregate Limit means the aggregate gross exposure restriction in section 2.9.1 of NI 81-102, which places an overall limit on a Fund's exposure to borrowing, short selling and derivatives equal to 300% of the Fund's NAV.
Fund means each existing and future "alternative mutual fund", as defined in NI 81-102, managed by the Filer or an affiliate or successor of the Filer, including the Initial Fund.
Fund Aggregate Limit means in relation to the Initial Fund, the limit set out in the Initial Fund's simplified prospectus that limits its aggregate exposure to cash borrowing, short selling and specified derivatives transactions, excluding any specified derivatives used for hedging purposes, to 200% of the Initial Fund's NAV.
Initial Fund means Dynamic Alpha Performance II Fund.
IPU means "index participation unit", as defined in NI 81-102.
IPU Issuer means an investment fund the securities of which are IPUs.
Specified IPU Issuer means each of the following IPU Issuers: (i) the SPDR® S&P 500 ETF, which trades on the NYSE Arca under the ticker symbol: SPY; or (ii) the SPDR® S&P MidCap 400 ETF, which trades on the NYSE Arca under the ticker symbol: MID.
The decision is based on the following facts represented by the Filer:
The Filer and the Funds
1. The Filer is a limited partnership established under the laws of Ontario. The Filer's head office is located in Toronto, Ontario.
2. The Filer, or an affiliate or successor of the Filer, is or will be, the registered investment fund manager of each Fund. The Filer, or an affiliate or successor of the Filer, is also or will also be, the registered portfolio manager of each Fund and the trustee of each Fund structured as a trust.
3. The Filer is registered as: (i) a portfolio manager in all of the provinces of Canada and in the Northwest Territories and the Yukon; (ii) an exempt market dealer in all of the provinces of Canada (except Prince Edward Island and Saskatchewan); (iii) an investment fund manager in Ontario, Québec, Newfoundland and Labrador and the Northwest Territories; and (iv) a commodity trading manager in Ontario.
4. Each Fund is, or will be, an "alternative mutual fund", as defined in NI 81-102, created under the laws of the Province of Ontario or another of the Jurisdictions and governed by NI 81-102, subject to any relief therefrom granted to the Fund by the securities regulatory authorities.
5. Neither the Filer, nor any of the existing Funds, is in default of any of the requirements of securities legislation in any of the Jurisdictions.
6. Securities of each Fund are, or will be, offered by prospectus filed in one or more of the Jurisdictions and, accordingly, each Fund is or will be a reporting issuer in one or more of the Jurisdictions.
7. The description of the investment objective of the Initial Fund, as set out in its simplified prospectus, includes the following: Dynamic Alpha Performance II Fund seeks to protect capital during a wide range of economic and market environments while earning superior risk-adjusted equity or equity related returns that are not correlated to major stock market indices. The Fund will use alternative investment strategies primarily including engaging in physical short sales and may also include purchasing securities on margin or with borrowed funds. The Fund aims to reduce risk and invest in a diversified portfolio of equity securities from around the world.
8. As part of its investment strategies, each Fund may: (i) purchase securities, including on margin or with borrowed funds; (ii) engage in short sales; and/or (iii) engage in derivative transactions to limit or hedge potential losses associated with securities, among other things.
9. Each Fund is subject to the Aggregate Limit and the Initial Fund is currently subject to the Fund Aggregate Limit. The Filer intends to continue with the Fund Aggregate Limit for the Initial Fund if the Requested Relief is granted.
10. Subject to applicable restrictions including the Aggregate Limit, each Fund may gain exposure, including short exposure, to IPUs of IPU Issuers by way of specified derivative transactions without impacting such Fund's ability to engage in cash borrowings and short sales.
11. The Filer's assessed risk rating of the Initial Fund is low to medium, and the Filer believes this risk rating would not change by virtue of relying on the Requested Relief.
IPU Issuers and the Specified IPU Issuers
12. IPU Issuers are generally diversified. IPU Issuers seek to provide investment results that correspond generally to the performance of a specified underlying market index comprised of multiple issuers by holding a portfolio of securities that are included in the index or otherwise investing in a manner that causes the IPU Issuer to replicate the performance of that index. The Specified IPU Issuers track underlying indices comprised of hundreds of issuers.
13. IPU Issuers are generally liquid. In respect of the Specified IPU Issuers, the volume of trading of the SPDR S&P 500 ETF routinely reaches over a hundred million securities exchanged on a daily basis. The volume of trading of the SPDR S&P MidCap 400 ETF routinely reaches over a million securities exchanged on a daily basis. Additionally, the creation process for IPUs of IPU Issuers can quickly increase the available supply of IPUs of IPU Issuers in the marketplace, making the potential for a liquidity issue inherently lower.
14. The weight of each underlying security held in an IPU Issuer substantially corresponds to the weight of such security in the underlying index. In respect of the Specified IPU Issuers, the S&P Midcap 400 Index is composed of 400 selected stocks all of which are listed on national stock exchanges, and span a broad range of major industry groups. The S&P 500 Index includes 500 selected companies, all of which are listed on national stock exchanges and spans over 24 separate industry groups.
15. The Specified IPU Issuers are "registered" investment companies in the United States, which means that there is mandated disclosure about the Specified IPU Issuers readily available in the marketplace.
16. The Specified IPU Issuers are publicly traded on the U.S. NYSE Arca stock exchange.
The Requested Relief
17. Sections 2.1(1) and 2.1(1.1) of NI 81-102 restrict an investment fund from purchasing a security of an issuer, entering into a specified derivatives transaction or purchasing an IPU if, immediately after the transaction, more than 10% of its NAV, in the case of a mutual fund other than an alternative mutual fund, or more than 20% of its NAV, in the case of an alternative mutual fund or non-redeemable investment fund, would be invested in securities of any one issuer (the Concentration Restriction).
18. Section 2.1(2) of NI 81-102 provides an exception to the Concentration Restriction for an IPU that is a security of an investment fund. The Filer has submitted that the rationale for this exception is in part that an IPU Issuer should be considered a look-through vehicle in that it is comprised of and represents a diversified group of issuers whose securities it holds in proportion to the underlying index, thereby mitigating the concentration risk otherwise associated with a fund holding the securities of a single issuer. The Filer believes a similar rationale applies to shorting IPU Issuers.
19. A significant risk associated with short positions generally is the potential to be unable to obtain the securities required to cover the short position, or to be unable to obtain them without additional costs, at the required time due to a lack of liquidity in the market. The Filer has submitted that the liquidity of the IPU Issuers as described above significantly reduces the risk that a Fund may not be able to cover or exit a short position in an IPU Issuer. On this basis, short sales of IPU Issuers will not have the same risk profile as a short sale of a single issuer or of a security that lacks liquidity of this magnitude.
20. The Funds are permitted to short sell IPUs of multiple IPU Issuers up to the limits of the Aggregate Short Restrictions. However, the Filer has submitted that shorting a single IPU Issuer is preferable in certain cases to shorting multiple IPU Issuers where the liquidity of the single IPU Issuer being sold short is higher than other IPU Issuers tracking the same index, or where the underlying index tracked by a particular IPU Issuer otherwise presents more favourable investment characteristics than other IPU Issuers.
21. The Filer is of the view that, in the case of IPU Issuers, given their high diversity and liquidity, the concentration risk otherwise associated with shorting securities of a single issuer is mitigated and, as a result, the Requested Relief would permit the Funds to benefit from efficiencies without prejudicing investors.
22. The Requested Relief is requested to permit each Fund to short sell IPUs of IPU Issuers without otherwise impacting such Fund's ability to borrow cash or engage in short sales under NI 81-102, in circumstances where the Filer believes that it is more beneficial to gain the desired short exposure to IPU Issuers: (a) through shorting fewer IPU Issuers than would otherwise be necessary under the Single Issuer Short Restriction; and (b) by way of short sales potentially in excess of the Aggregate Short Restrictions rather than by way of specified derivative transactions.
23. The Requested Relief would permit the Initial Fund to effectively pursue its investment strategies, namely, by protecting capital and reducing risk through hedging. Such a strategy will mitigate the impact of price changes on such Fund's portfolio. To hedge against market volatility, the Initial Fund would hold long positions in certain individual issuers that are included in an index, concurrent with holding offsetting short exposure to the relevant index. The effect of this strategy would be to hedge away risks of the general market (i.e. beta), while preserving idiosyncratic returns of the long positions in such individual issuers held by the Initial Fund. As a result, the Filer believes the Requested Relief would provide the potential for compelling, low volatility returns to investors.
24. While the Initial Fund could acquire exposure, including short exposure, to the Specified IPU Issuers and other IPU Issuers in pursuit of its investment strategies through derivative transactions, the Filer believes that short sales of the Specified IPU Issuers may provide a faster, more efficient and flexible means of achieving diversification and hedging against market risk. The Filer believes that while the underlying indices of the Specified IPU Issuers trade as futures contracts on the Chicago Mercantile Exchange, the use of this alternative form of leverage, through futures, can be less liquid, more cumbersome and less flexible, and therefore ultimately potentially riskier to investors of the Fund.
25. As such, the Filer is of the view that it would be in the Initial Fund's best interest to permit it to physically short sell IPUs of IPU Issuers, up to 100% of the Fund's NAV at the time of sale, instead of being limited to achieving that degree of leverage through either specified derivatives alone, or a combination of physical short selling and specified derivatives, including for the following reasons. In some circumstances, the availability of derivatives with similar risk characteristics to corresponding indices may be limited. Alternatively, pricing of a short position at a particular point in time may be preferable to the pricing of a corresponding derivatives contract. Granting the Requested Relief would expand the scope of available tools at the disposal of the portfolio manager to achieve market hedging, and thereby provide the portfolio manager with the best execution and best liquidity. As an example, at times the Specified IPU Issuers trade more frequently than similar derivatives contracts. At such times, there may be reduced risk when covering short positions comparatively to closing out a derivatives transaction through offsetting positions. In addition, the Requested Relief may also be less risky than certain derivatives transactions by allowing the Fund to, in part, mitigate against settlement risk (which is the risk that one of the parties to the derivatives contract defaults under the derivatives contract). Use of derivatives may also be incrementally riskier by exposing the Fund to operational risk (such as the case of a party to a derivatives contract failing to maintain adequate internal procedures or controls including intra-day settlements or managing closing-out the transaction) and liquidity risk.
26. The Requested Relief would allow the portfolio manager of the Funds greater flexibility and liquidity in pursuing a hedging strategy that reduces potential market volatility by expanding options for hedging to include selling highly liquid IPU Issuers short.
27. Notwithstanding the Requested Relief, the Funds would otherwise still be required to comply with all of the requirements applicable to alternative mutual funds in sections 2.6.1 and 2.6.2 of NI 81-102, including with the 50% of NAV restriction on cash borrowing and the 50% of NAV restriction on short selling securities (in respect of securities that are not IPUs of IPU Issuers) in paragraphs 2.6(2)(c) and 2.6.1(1)(c)(v) of NI 81-102 respectively and with the total borrowing and short sale limits in section 2.6.2 of NI 81-102.
28. The Requested Relief would not change each Fund's obligation to comply with the Aggregate Limit. The Fund Aggregate Limit would continue to apply to the Initial Fund's combined exposure to borrowing, short selling and derivatives and the Requested Relief. The Aggregate Limit would continue to apply to a Fund's combined exposure to borrowing, short selling and derivatives and the Requested Relief. A decision to grant the Requested Relief would not permit the Initial Fund to exceed the Fund Aggregate Limit, or a Fund to exceed the Aggregate Limit, through a combination of investment strategies.
29. If the aggregate gross exposure were to exceed the Aggregate Limit, section 2.9.1(5) of NI 81-102 would require a Fund to, as quickly as commercially reasonable, take all necessary steps to reduce the aggregate gross exposure to 300% of the Fund's NAV or less.
30. Each short sale will be made consistent with the Fund's investment objectives and strategies.
31. Each Fund will implement the following controls when conducting a short sale:
(a) the Fund will assume the obligation to return to the Borrowing Agent (as defined in NI 81-102) the securities borrowed to effect the short sale;
(b) the Fund will receive cash for the securities sold short within normal trading settlement periods for the market in which the short sale is effected;
(c) the Filer will monitor the short positions of the Fund at least as frequently as daily;
(d) the security interest provided by the Fund over any of its assets that is required to enable the Fund to effect a short sale transaction is made in accordance with section 6.8.1 of NI 81-102 and will otherwise be in accordance with industry practice for that type of transaction and relates only to obligations arising under such short sale transactions;
(e) the Fund maintains appropriate internal controls regarding short sales, including written policies and procedures for the conduct of short sales, risk management controls and proper books and records; and
(f) the Filer and the Fund keep proper books and records of short sales and all of its assets deposited with Borrowing Agents as security.
32. Each Fund's prospectus will contain adequate disclosure of the Fund's short selling activities, including the material terms of the Requested Relief.
33. For the reasons provided above, the Filer respectfully submits that it would not be prejudicial to the public interest to grant the Requested Relief.
The principal regulator is satisfied that the decision meets the test set out in the Legislation for the principal regulator to make the decision. The decision of the principal regulator under the Legislation is that the Requested Relief is granted, provided that:
1. The only securities that a Fund will sell short in an amount that exceeds 50% of the Fund's NAV at the time of sale will be IPUs of IPU Issuers;
2. The only securities that a Fund will sell short (other than "government securities", as defined in NI 81-102), resulting in the aggregate market value of the securities of that issuer sold short by the Fund exceeding 10% of the Fund's NAV at the time of sale, will be IPUs of IPU Issuers;
3. The relief from the Single Issuer Short Restriction granted by this decision only applies in respect of a Fund's short sales of IPUs of an IPU Issuer and each Fund will comply with the Single Issuer Short Restriction in respect of its exposure to the securities held by each IPU Issuer the IPUs of which the Fund sells short. For each IPU of an IPU Issuer the Fund sells short, the Fund will be considered to be directly selling short its proportionate share of the securities held by the IPU Issuer, except that it will not be considered to be directly selling short a security or instrument that is a component of, but represents less than 10% of, the securities held by the IPU Issuer;
4. A Fund may sell an IPU of an IPU Issuer short or borrow cash only if, immediately after the transaction:
(a) the aggregate market value of all securities sold short by the Fund does not exceed 100% of the Fund's NAV;
(b) the aggregate value of cash borrowing by the Fund does not exceed 50% of the Fund's NAV; and
(c) the aggregate market value of securities sold short by the Fund combined with the aggregate value of cash borrowing by the Fund does not exceed 100% of the Fund's NAV;
5. Each Fund will otherwise comply with all of the requirements applicable to alternative mutual funds in sections 2.6.1 and 2.6.2 of NI 81-102;
6. A Fund's aggregate exposure to short selling, cash borrowing and specified derivatives will not exceed the Aggregate Limit;
7. Each short sale will be made consistent with the Fund's investment objectives and investment strategies; and
8. Each Fund's prospectus discloses that the Fund is able to sell short IPUs of one or more IPU Issuers in an amount up to 100% of the Fund's NAV at the time of sale, including the material terms of this decision.