National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions -- filer seeking relief from NI 81-102 to permit alternative mutual funds to physically short sell up to 100% of net assets -- funds could achieve similar short exposure through derivatives under NI 81-102 -- physical short selling is generally more efficient and will not increase risk to the funds compared to similar short exposure through derivatives -- relief subject to conditions.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds -- ss. 2.6.1(1)(c)(v), 2.6.2 (1), 19.1.
May 19, 2020
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 WARATAH CAPITAL ADVISORS LTD. (the Filer) AND WARATAH ALTERNATIVE ESG FUND (the Existing Fund)
The principal regulator in the Jurisdiction has received an application (the Application) from the Filer on behalf of the Existing Fund and similarly structured investment funds managed by the Filer (the Future Funds and, collectively with the Existing Fund, the Funds) for a decision under the securities legislation of the Jurisdiction (the Legislation) that exempts the Funds from the restrictions in subparagraph 2.6.1(1)(c)(v) and section 2.6.2 of NI 81-102 in order to permit each Fund to borrow securities from a borrowing agent to sell securities short whereby (A) the aggregate market value of all securities sold short by the Fund may exceed 50% of the net asset value of the Fund; and (B) the aggregate market value of securities sold short combined with the aggregate value of cash borrowed by the Fund may exceed 50% of the Fund's net asset value, provided that, the aggregate market value of securities sold short combined with the aggregate amount of cash borrowed does not exceed 100% of the net asset value of the Fund (the Exemption Sought).
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):
(i) the Ontario Securities Commission is the principal regulator for the Application;
(ii) the Filer has provided notice that subsection 4.7(1) of Multilateral Instrument 11-202 Passport System (MI 11-102) is intended to be relied upon in each of British Columbia, Alberta, Saskatchewan, Manitoba, Québec, New Brunswick and Nova Scotia (the Other Jurisdictions and, together with the Jurisdiction, the Canadian Jurisdictions).
Terms defined in National Instrument 14-101 Definitions have the same meaning if used in this decision, unless otherwise defined;
AIF means an annual information from of a Fund prepared in accordance with Form 81-101F2 -- Contents of Annual Information Form under NI 81-101 Mutual Fund Prospectus Disclosure (NI 81-101), as the same may be amended from time to time;
NAV means net asset value;
Prime Broker means any entity that acts as a lender or borrowing agent, as the case may be, to one or more investment funds;
Prospectus means a simplified prospectus of a Fund prepared in accordance with Form 81-101F1 -- Contents of Simplified Prospectus under NI 81-101 as the same may be amended from time to time; and
Short Selling Limit means the limit of 50% of NAV for short sale transactions by alternative mutual funds set out in subparagraph 2.6.1(1)(c)(v) of NI 81-102.
This decision is based on the following facts represented by the Filer:
1. The Filer is a corporation incorporated under the laws of the Province of Ontario. The head office of the Filer is in Toronto, Ontario.
2. The Filer is registered as an investment fund manager, portfolio manager and exempt market dealer in the Province of Ontario; an investment fund manager and exempt market dealer in the Province of Québec; and an exempt market dealer in the Provinces of British Columbia, Alberta; Manitoba, Saskatchewan, New Brunswick and Nova Scotia.
3. The Filer is the investment fund manager and portfolio manager of the Existing Fund and will be the investment fund manager and portfolio manager of the Future Funds. As such, the Filer is, or will be, responsible for managing the assets of the Funds and has, or will have, complete discretion to invest and reinvest the Funds' assets and is, or will be, responsible for executing all portfolio transactions.
4. The Filer is not in default of applicable securities legislation in any of the Canadian Jurisdictions.
5. Each of the Funds is, or will be, organized as a trust established under the laws of the Province of Ontario or another Canadian Jurisdiction.
6. Each of the Funds is, or will be, an open-ended public alternative mutual fund governed by NI 81-102.
7. Units of the Funds are, or will be, offered by a Prospectus, AIF and fund facts documents filed in one or more of the Canadian Jurisdictions and, accordingly, each Fund is, or will be, a reporting issuer in the Canadian Jurisdictions where the Exemption Sought is relied upon.
Reasons for the Exemption Sought
8. The investment objectives to be utilized by each of the Funds will differ but, in each case, a key investment strategy which may be utilized by a Fund will include the use of market-neutral, offsetting, inverse or shorting strategies requiring the use of short selling in excess of the Short Selling Limit.
9. Market-neutral strategies are well-recognized for limiting market risk, balancing long and short positions within an investment portfolio with the objective of providing positive returns regardless of whether the broader market rises, falls or is flat. Market-neutral strategies are designed to have less volatility than the broader market when measured over medium to long-term periods. Market-neutral strategies also provide diversification to investors as returns are intended to be uncorrelated to the performance of the broader market -- such strategies are designed to effectively remove any "beta" component from their returns and investment exposures.
10. As part of an investment strategy, short positions can serve as both a hedge against exposure to a long position, or a group of long positions, and also as a source of returns with an offsetting long position or positions. The Funds will generally seek to generate an attractive risk/return profile independent of the direction of the broad equity markets. As such, at the portfolio level, these strategies seek to hedge out the Fund's exposure to the direction of broad equity markets, and to generate positive performance from the difference, specifically, the spread between the performance of the portfolio's long and short positions.
11. The investment strategies of each Fund permit, or will permit, it to sell securities short provided that, at the time the Fund sells a security short (i) the aggregate market value of securities of any one issuer (other than "government securities" as defined in NI 81-102) sold short by the Fund does not exceed 10% of the NAV of the Fund; and (ii) the aggregate market value of all securities sold short by the Fund does not exceed 100% of its NAV.
12. The investment strategies of each Fund permit, or will permit, it to enter into a cash borrowing (to a maximum of 50% of the Fund's NAV) or short selling transaction, provided that the aggregate value of cash borrowed combined with the aggregate market value of the securities sold short by the Fund does not exceed 100% of the Fund's NAV (the Total Borrowing and Short Selling Limit). If the Total Borrowing and Short Selling Limit is exceeded, the Fund shall, as quickly as is commercially reasonable, take all necessary steps to reduce the aggregate value of cash borrowed combined with the aggregate market value of securities sold short to be within the Total Borrowing and Short Selling Limit.
13. The investment strategies of each Fund will permit the Fund to borrow cash, enter into specified derivatives transactions or sell securities short, provided that immediately after entering into a cash borrowing, specified derivative or short selling transaction, the aggregate value of cash borrowed combined with the aggregate market value of securities sold short and aggregate notional amount of the Fund's specified derivatives positions (other than positions held for hedging purposes, as defined in NI 81-102) would not exceed 300% of the NAV of the Fund as set out in subsection 2.9.1(5) of NI 81-102 (the Leverage Limit). If the Leverage Limit is exceeded, the Fund shall, as quickly as is commercially reasonable, take all necessary steps to reduce the aggregate value of cash borrowed combined with the aggregate market value of securities sold short and the aggregate notional amount of the Fund's specified derivatives positions (other than positions held for hedging purposes) to be within the Leverage Limit.
14. An alternative mutual fund that is subject to NI 81-102 is permitted to take leveraged long and short positions using specified derivatives up to a maximum of 300% of its NAV. As such, the Exemption Sought would not be required if the Funds utilized solely specified derivatives (such as over-the-counter total return swaps) to obtain short exposure to the underlying securities. NI 81-102 contemplates that alternative mutual funds may utilize shorting strategies (using a combination of short sale transactions and specified derivatives) subject to the Short Selling Limit and the Leverage Limit. Alternative mutual funds that were previously known as commodity pools provide 100% or 200% inverse exposure through the use of specified derivatives, which is consistent with the Leverage Limit and does not trigger the application of the Short Selling Limit for which the Filer is requesting exemptive relief. Accordingly, the Exemption Sought would simply allow the Funds to do directly what they could otherwise do indirectly through the use of specified derivatives.
15. The Exemption Sought would allow the Funds to offset the beta of their long positions through short positions in order to strategically reduce portfolio volatility where the Filer has identified potential downside risks to the market without the necessity of resorting to specified derivatives, which, as further detailed below, can be more beneficial in certain circumstances. In implementing the Funds' objectives, the Filer seeks to reduce or hedge expected market exposure in order to mitigate the downside impact of market risks. This strategy is designed to be achieved by offsetting the long positions in a portfolio of securities that are expected to outperform (or to provide exposure to a particular investment strategy) against the portfolio's short positions that are expected to underperform (or to balance market risk by shorting securities that do not have the characteristics targeted under the long investment strategy). As a result, the use of a short-selling strategy provides for greater diversification as it is uncorrelated to the movements of the broader markets.
16. The Funds require the flexibility to enter into physical short positions when doing so is, in the opinion of the Filer, in the best interests of the applicable Fund and to not be obligated to utilize an equivalent short position synthetically through the use of specified derivatives as a result of regulatory restrictions in NI 81-102 that do not provide any material benefit or protection to investors.
17. The Filer, as a registrant and a fiduciary, is in the best position to determine whether the Funds should enter into a physical short position versus achieving the same result through the use of specified derivatives, depending on the surrounding circumstances. Accordingly, the Exemption Sought would permit the Filer to engage in the most effective portfolio management available for the benefit of the Funds and their unitholders.
18. In addition, while there may be certain situations in which using a synthetic short position may be preferable, physical shorts are typically less costly, because of the ability to execute trades with a larger number of counterparties, compared to a single counterparty for synthetic shorts. This can result in wider options for borrowing securities resulting in lower borrowing costs. Alternative mutual funds may also be exposed to less counterparty risk than with a synthetic short position (e.g. counterparty default, counterparty insolvency and premature termination of derivatives).
19. Any physical short position or cash borrowing transaction entered into by a Fund will be consistent with the investment objectives and strategies of the applicable Fund.
20. The Exemption Sought would provide the Filer, a registrant with significant expertise in these areas, with the required flexibility to make timely trading decisions between physical and synthetic short sale positions. The Exemption Sought is necessary in order to permit the Filer to engage in the most effective portfolio management activities on behalf and for the benefit of the Funds and their unitholders.
21. The Prospectus, AIF and fund facts documents will comply with the requirements of NI 81-101 applicable to alternative mutual funds, including cover page text box disclosure in the fund facts to highlight how the Fund differs from other mutual funds and emphasize that short selling strategies permitted for the Fund are outside the scope of the restrictions in NI 81-102 applicable to both mutual funds and alternative mutual funds.
22. The investment strategies of each Fund will clearly disclose that short selling strategies of the Fund which are outside the scope of NI 81-102, including that the aggregate market value of all securities sold short by the Fund may exceed 50% of the NAV of the Fund. The Prospectus will also contain appropriate risk disclosure, alerting investors of any material risks associated with such investment strategies.
23. The Filer will determine the risk rating for each Fund using the Investment Risk Classification Methodology as set out in Appendix F of NI 81-102.
24. The Filer has comprehensive risk management policies and/or procedures that address the risks associated with short selling in connection with the implementation of the investment strategy of each Fund.
25. 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 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 within the constraints of the Exemption Sought as 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 industry practice for that type of transaction and relates only to obligations arising under such short sale transactions;
(e) the Filer will maintain 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 will keep proper books and records of short sales and all assets of a Fund deposited with borrowing agents as security.
26. The Filer believes that it is in the best interests of each of the Funds to be permitted to engage in physical short selling and to obtain additional investment exposure through the use of cash borrowing in excess of the current limits set out in NI 81-102.
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 Exemption Sought is granted provided that:
1. A Fund may sell a security short or borrow cash only if, immediately after the cash borrowing or short selling 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 Alternative Fund's NAV;
(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; and
(d) the Fund's aggregate exposure to short selling, cash borrowing and specified derivatives does not exceed the Leverage Limit.
2. In the case of a short sale, the short sale:
(a) otherwise complies with all of the short sale requirements applicable to alternative mutual funds under section 2.6.1 and 2.6.2 of NI 81-102; and
(b) is consistent with the Fund's investment objectives and strategies.
3. The Prospectus under which units of a Fund are offered:
(a) discloses that the Fund can short sell securities having an aggregate market value of up to 100% of the Fund's NAV; and
(b) describes the material terms of this decision.