1832 Asset Management L.P. and Dynamic Credit Absolute Return II Fund
National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions -- Relief granted from short selling restrictions in NI 81-102 to permit alternative mutual funds to short sell "government securities", as defined in NI 81-102, up to 300% of NAV, subject to conditions.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds -- ss. 2.6.1, 2.6.2 and 19.1.
June 21, 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 ANDIN THE MATTER OF 1832 ASSET MANAGEMENT L.P. (the Filer) AND IN THE MATTER OF DYNAMIC CREDIT ABSOLUTE RETURN II FUND (the Initial Fund) and any future alternative mutual funds, as that term is defined in National Instrument 81-102 Investment Funds (NI 81-102), managed by the Filer or an affiliate of the Filer (the Future Funds, together with the Initial Fund, the Funds)
The principal regulator in the Jurisdiction has received an 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) exempting the Funds from the following provisions of NI 81-102 in order to permit the Funds to short sell "government securities", as that term is defined in NI 81-102 and set out below (Government Securities), up to a maximum of 300% of a Fund's net asset value (NAV) (the Requested Relief):
(a) subparagraph 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
(b) 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, the Short Selling Restrictions).
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):
(i) the Ontario Securities Commission is the principal regulator for this application; and
(ii) the Filer has provided notice that subsection 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in each of the other provinces and territories of Canada (together with the Jurisdiction, the Jurisdictions).
Terms defined in MI 11-102, National Instrument 14-101 Definitions and NI 81-102 have the same meaning if used in this decision, unless otherwise defined. For ease of reference, "Government Security", as defined in NI 81-102 and used in this decision, means an evidence of indebtedness issued, or fully and unconditionally guaranteed as to principal and interest, by any of the government of Canada, the government of a province or territory of Canada, or the government of the United States of America.
This decision is based on the following facts represented by the Filer on behalf of itself 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 will be the trustee, investment fund manager and the portfolio manager of the Initial Fund. The Filer or an affiliate of the Filer will be the investment fund manager of the Future Funds.
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. The Filer is not in default of securities legislation in any Jurisdiction.
5. Each Fund will be a mutual fund created under the laws of the Province of Ontario or another Jurisdiction and will be governed by NI 81-102, subject to any relief therefrom granted by the securities regulatory authorities.
6. Each Fund will be an "alternative mutual fund" as defined in NI 81-102.
7. The Initial Fund is not in default of securities legislation in any Jurisdiction.
8. Securities of each Fund will be offered by simplified prospectus filed in one or more of the Jurisdictions and, accordingly, each Fund will be a reporting issuer in one or more of the Jurisdictions.
9. The proposed investment objective of the Initial Fund is to maximize absolute returns over a complete market cycle through investment in diversified long and short positions of North American credit securities while seeking to mitigate interest rate risk while maintaining a weighted averaged credit rating of "Investment Grade". The Initial Fund will use alternative investment strategies including the use of leverage.
10. The Initial Fund may use leverage created primarily through physical short sales of fixed-income securities and other portfolio assets as well as leverage created by borrowing cash for investment purposes and/or the use of specified derivatives.
The Short Hedging Strategy
11. The Requested Relief would permit the Initial Fund to effectively pursue one of its investment strategies, namely, purchasing corporate bonds primarily with maturities of five years or less to take advantage of pricing changes as the corporate bonds approach maturity and roll down the yield curve, while short selling Government Securities of equivalent maturities to reduce interest rate sensitivity (the Short Hedging Strategy). The Filer believes this strategy will mitigate the impact of changes in interest rates on the Initial Fund's portfolio.
12. The Filer has submitted that short sales of fixed income securities have a significantly different risk profile than short sales of equity securities. Where equity securities have the potential to significantly increase in value, the risk to a mutual fund that has sold an equity security short is much higher. In theory a mutual fund that has sold an equity security short may bear unlimited losses. With fixed income securities, there is a more limited downside given that the security will mature and that when it matures it will typically mature at the security's par value. In this scenario, a fund's risk at maturity is limited to the security's par value and the carrying cost of the short position.
13. For the reasons in the Filer's submissions referenced above, the Filer believes that from a risk management perspective, short sales of Government Securities are comparatively more straightforward to manage in that a fund's portfolio advisor knows the maturity price of the security. As a strategy to mitigate the impact of changes in interest rates on a fund's portfolio, the Filer believes the Short Hedging Strategy is a highly effective way to manage the portfolio's duration.
14. Ultimately, the Requested Relief would allow the Initial Fund to take a levered position in liquid, short-term investment grade corporate bonds with the increased potential returns associated with these investments, while managing the Initial Fund's duration and risk of mark-to-market losses on the corporate bond positions.
15. There are a number of specific reasons why the Filer believes the flexibility to execute the Short Hedging Strategy up to 300% of the Initial Fund's NAV would benefit the Initial Fund versus being limited to either using specified derivatives alone, or a combination of physical short selling and specified derivatives. Such short sales of Government Securities would enable the Filer to hedge and to remove interest rate risk more accurately across the maturity spectrum as compared to utilizing interest rate futures. There are hundreds of different available Government Securities in the market with varying maturities as opposed a limited number of interest rate futures available in Canada. If the Initial Fund were to hedge such risks through interest rate futures for maturities that did not correspond accurately to the interest rate risks the Initial Fund was trying to mitigate, there is the possibility that such risks could not be effectively mitigated, which would increase the Initial Fund's general level of risk and prevent it from achieving one of its fundamental investment objectives. A further limitation of interest rate futures is their liquidity. Particular interest rate future contracts may lack sufficient liquidity at a given moment in time.
16. Another type of specified derivative the Initial Fund could use to mitigate interest rate exposure is interest rate swaps. Although interest rate swaps may be customized to fit different available maturities, they are operationally more burdensome and require cumbersome legal agreements with potential trading counterparties. While the Filer will utilize interest rate swaps where appropriate, short selling Government Securities is a highly liquid and efficient means of removing interest rate risk from the portfolio.
17. 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 Government Securities, up to 300% of the Fund's NAV, 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:
(a) While derivatives can be used to create similar investment exposure as the Short Hedging Strategy up to 300% of the Initial Fund's NAV, the use of derivatives is less effective, is more complex, and is riskier than the Short Hedging Strategy. Derivatives provide credit exposure that is less targeted than the Short Hedging Strategy with a longer duration that increases risk, often without commensurately higher returns. In addition, implementing derivatives necessitates incremental transactional steps. These steps increase both operational risk and counterparty risk, as well as cost.
(b) The risk of covering short Government Securities positions in a rising market is largely mitigated by several factors: (i) the strong correlation between the government security sold short and the corporate fixed income security held long by the Initial Fund which provides a hedge against short cover risk; (ii) Government Securities are highly liquid and more than one issuance of Government Securities can be used to hedge interest rate risk; (iii) Government Securities have markedly lower price volatility than equity securities; (iv) unlike equity securities, Government Securities have an effective upper value limit; and (v) financial institutions that facilitate short selling are regulated and implement effective risk controls on short sellers.
18. Short selling Government Securities in this manner also permits the Initial Fund use the proceeds of the sales to buy cash corporate bonds as opposed to seeking additional synthetic exposure. Long and short sales of Government Securities by the Initial Fund will be considerably easier to trade and settle than certain specified derivatives the Initial Fund could utilize.
19. Notwithstanding the Requested Relief, the Funds would 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 that are not Government Securities in paragraphs 2.6(2)(c) and 2.6.1(1)(v) of NI 81-102 respectively and with the total borrowing and short sale limits in section 2.6.2 of NI 81-102.
20. The Requested Relief would not change each Fund's obligation to comply with 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 (the Aggregate Leverage Limit).
21. The Aggregate Leverage 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 a Fund to exceed the Aggregate Leverage Limit through a combination of investment strategies.
22. If the aggregate gross exposure were to exceed the Aggregate Leverage Limit, subsection 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.
23. Each short sale will be made consistent with the Fund's investment objectives and strategies.
24. 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 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.
25. Each Fund's simplified prospectus will contain adequate disclosure of the Fund's short selling activities, including the material terms of the Requested Relief.
26. 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 which a Fund will sell short in an amount that exceeds 50% of the Fund's NAV will be securities that meet the definition of "Government Security" as that term is defined in NI 81-102.
2. Each short sale made by a Fund will otherwise comply with all of the short sale requirements applicable to alternative mutual funds in sections 2.6.1 and 2.6.2 of NI 81-102.
3. A Fund's aggregate exposure to short selling, cash borrowing and specified derivatives will not exceed the Aggregate Leverage Limit.
4. Each short sale will be made consistent with the Fund's investment objectives and investment strategies.
5. Each Fund's simplified prospectus discloses that the Fund is able to short sell Government Securities (as defined in NI 81-102) in an amount up to 300% of the Fund's NAV, including the material terms of this decision.