Horizons ETFS Management (Canada) Inc. and Horizons Tactical Absolute Return Bond Fund
Headnote
National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions -- Relief granted from short selling and cash borrowing restrictions in NI 81-102 to permit alternative mutual funds to conduct physical short sales and cash borrowing up to a combined aggregate limit of 100% of the fund's net asset value, subject to conditions.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds, ss. 2.6, 2.6.1, 2.6.2, 6.1 and 19.1.
March 1, 2021
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 HORIZONS ETFS MANAGEMENT (CANADA) INC. (the Filer) AND IN THE MATTER OF HORIZONS TACTICAL ABSOLUTE RETURN BOND FUND (the Existing Fund) and any exchange traded funds structured as "alternative mutual funds" as defined in National Instrument 81-102 Investment Funds (NI 81-102) managed by the Filer in the future (the Future Funds and, collectively with the Existing Fund, the Funds)
DECISION
Background
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 (the Legislation) exempting each Fund from the following restrictions of NI 81-102 to permit each Fund to sell securities short and/or borrow cash up to a combined aggregate total of 100% of the net asset value (NAV) of the Fund:
(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 all securities sold short by the Fund exceeds 50% of the Fund's NAV (together with (c) below, the Short Selling Limit);
(b) Subparagraph 2.6(2)(c), which restricts a Fund from borrowing cash if the value of cash borrowed, when aggregated with the value of all outstanding borrowing by the Fund, exceeds 50% of the Fund's NAV (together with (c) below, the Cash Borrowing Limit); 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 all 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
((a) and (c) together, the Short Selling Relief, (b) and (c) together, the Cash Borrowing Relief. The Short Selling Relief and the Cash Borrowing Relief together, the Requested Relief).
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).
Interpretation
Terms defined in National Instrument 14-101 Definitions have the same meaning if used in this decision, unless otherwise defined.
Prime Broker means any entity that acts as a lender or borrowing agent, as the case may be, to one or more investment funds; and
Prospectus means a prospectus of a Fund prepared in accordance with Form 41-101F2 Information Required in an Investment Fund Prospectus, as may be amended from time to time.
Representations
This decision is based on the following facts represented by the Filer:
The Filer and the Funds
1. The Filer is a corporation existing under the federal laws of Canada.
2. The Filer's head office is located in Toronto, Ontario.
3. The Filer is registered as (a) an investment fund manager in Newfoundland and Labrador, Ontario and Québec, (b) a portfolio manager in Alberta, British Columbia, Ontario and Québec, (c) a dealer in the category of exempt market dealer in Alberta, British Columbia, Manitoba, New Brunswick, Newfoundland and Labrador, Nova Scotia, Ontario, Prince Edward Island, Québec and Saskatchewan, (d) a commodity trading adviser in Ontario and (e) a commodity trading manager in Ontario.
4. The Filer is the investment fund manager and portfolio manager of the Existing Fund and has retained DMAT Capital Management Inc. as sub-advisor. The Filer will be the investment fund manager of the Future Funds and will be the portfolio manager of the Future Funds or may engage another registered portfolio manager to act as the portfolio manager of one or more Future Funds from time to time in accordance with applicable securities laws. The Filer may also in its capacity as portfolio manager appoint one or more sub-advisers of one or more Future Funds from time to time in accordance with applicable securities laws.
5. The Existing Fund is (a) an exchange traded alternative mutual fund structured as a separate class of shares of Horizons ETF Corp., a mutual fund corporation established under the federal laws of Canada; and (b) an "alternative mutual fund" as defined in and governed by NI 81-102. Any Future Fund may be structured as a class of shares of a mutual fund corporation or as a trust and will be an "alternative mutual fund" as defined in and governed by NI 81-102.
6. Shares of the Funds are or will be offered by Prospectus and ETF Facts filed in all of the Jurisdictions where the Requested Relief is relied upon and, accordingly, each Fund is or will be a reporting issuer in the Jurisdictions where the Requested Relief is relied upon.
7. Neither the Filer nor the Existing Fund is in default of applicable securities legislation in any of the Jurisdictions.
Reasons for the Requested Relief
8. The investment objective of each Fund will differ but, in each case, key investment strategies which may be utilized by a Fund will include (a) the use of absolute return, offsetting, inverse or shorting strategies requiring the use of short selling in excess of the Short Selling Limit and/or (b) the use of cash borrowing to provide additional investment exposure in connection with the investment strategies of the Fund in excess of the Cash Borrowing Limit.
9. The investment objective of the Existing Fund is to seek to provide positive absolute returns with low volatility over a market cycle regardless of market conditions or general market direction. The Existing Fund will tactically take long and short positions in North American and global debt instruments and derivatives across the credit spectrum. A core investment strategy, as stated in the Prospectus of the Existing Fund, is that the Existing Fund will make extensive use of short selling.
10. The Prospectus of the Existing Fund discloses that the Filer has applied for exemptive relief to permit the aggregate market value of any securities sold short by the Existing Fund combined with the aggregate value of cash borrowing, if any, to be subject to an overall limit of 100% of its NAV.
11. The goal of absolute return investing is to generate returns that are independent of the returns and direction of the stock market (called beta). Absolute return investing is often implemented through a long/short portfolio of investments in publicly traded stocks. The market exposures of the combined long and short positions are designed to cancel each other out, producing a net effect on portfolio returns from stock market returns close to zero. An absolute return strategy seeks positive returns, regardless of whether the stock market goes up or down.
12. The ability to engage in additional short selling and cash borrowing in connection with the investment strategies of a Fund may provide cost savings to the Fund compared to obtaining the same level of investment exposure through the use of specified derivatives while, at the same time, not increasing the overall level of risk to the Fund. The costs to the Funds of engaging in physical short sales and cash borrowing are typically less when compared to the equivalent derivative transactions due to a number of factors which may include:
(a) Prime Brokers typically have greater flexibility to offer more favourable financing terms to a Fund in relation to the aggregate amount of the Fund's assets held in the prime brokerage margin account. Derivative instruments, such as futures contracts and over the counter (OTC) derivatives, are not held in a prime brokerage account and therefore reduce the ability of a Fund to obtain the most beneficial pricing terms available.
(b) Margin requirements for derivative instruments are primarily based on the underlying investment exposure and, as a result, can be high.
(c) Certain derivative instruments (such as futures contracts) require cash or near cash securities (such as government treasuries) to be deposited with the counterparty as collateral. This would require a Fund to use these portfolio assets to satisfy collateral requirements rather than utilizing them in connection with the Fund's investment strategy.
13. The Funds may use cash borrowing as a more flexible and cost-efficient means of providing additional leverage for investment strategies such as merger arbitrage strategies where the use of derivative instruments to provide the same level of exposure may not be practical. In addition, cash borrowing is more efficient to utilize on a day to day basis compared to derivative instruments which generally require a higher degree of negotiation and ongoing administration on the part of the Filer. The Cash Borrowing Relief would provide the Filer with access to a more functional source of additional leverage to utilize on behalf of the Funds at a lower cost which, in turn, would benefit investors.
14. The investment strategies of each Fund permit, or will permit, it to:
(a) 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;
(b) borrow cash provided that, at the time, the value of cash borrowed when aggregated with the value of all outstanding borrowing by the Fund does not exceed 100% of the Fund's NAV;
(c) borrow cash or sell securities short, 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; and
(d) borrow cash, sell securities short or enter into specified derivatives transactions, provided that immediately after entering into a cash borrowing, short selling or specified derivative 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 section 2.9.1 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.
15. While there may be certain situations where using a synthetic short position may be preferable, physical short positions 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 lower borrowing costs for the Fund and reduce its exposure to counterparty risk (e.g. counterparty default, counterparty insolvency and premature termination of derivatives) compared to a synthetic short position. The Requested Relief would provide the portfolio manager of the Fund with the necessary flexibility to make timely trading decisions between physical short and synthetic short positions based on what is in the best interest of the Fund.
16. The portfolio manager of the Fund, as a registrant and a fiduciary, is in the best position to determine whether the Fund should enter into a physical short position and/or obtain additional investment exposure via cash borrowing, versus achieving the same result through the use of specified derivatives. depending on the surrounding circumstances. Accordingly, the Requested Relief would permit the Fund to engage in the most effective portfolio management available for the benefit of its investors.
17. 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 the Leverage Limit. As such, the Short Selling Relief and Cash Borrowing Relief would not be required if the Funds utilized solely specified derivatives (such as OTC total return swaps) to obtain short exposure to the underlying securities or to provide additional investment exposure in connection with the Fund's investment strategies. Accordingly, the Short Selling Relief and Cash Borrowing Relief would simply allow the Funds to do directly what they could otherwise do indirectly through the use of specified derivatives.
18. The Funds require the flexibility to enter into physical short positions and borrow cash 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 or amount of leverage synthetically through the use of specified derivatives as a result of regulatory restrictions in NI 81-102 that the Filer believes do not provide any material additional benefit or protection to investors.
19. The Filer believes that the Short Selling Relief and the Cash Borrowing Relief would allow the Filer to more effectively manage each Fund's investment exposure by providing it with the ability to respond to market developments in a timely manner and enabling the Filer to reduce the related expenses incurred by the Funds.
20. 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.
21. The Prospectus and ETF Facts, as applicable, will comply with the applicable requirements of National Instrument 41-101 General Prospectus Requirements and Form 41-101F4 Information Required in an ETF Facts Document for alternative mutual funds and will include (in respect of the Existing Fund, upon next renewal or amendment) cover page text box disclosure in the ETF Facts to highlight how the Fund differs from other mutual funds and alternative mutual funds and emphasize that the short selling and cash borrowing strategies and increased ability to engage in short selling and cash borrowing 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 Prospectus investment strategies of each Fund will, to the extent applicable, disclose that the short selling and cash borrowing strategies of the Fund are outside the scope of NI 81-102.
23. The Prospectus will also contain appropriate risk disclosure, alerting investors of any material risks associated with such investment strategies.
24. The Filer does not consider that granting the Short Selling and Cash Borrowing Relief would constitute either a fundamental or material change for the Existing Fund under NI 81-102 or National Instrument 81-106 Investment Fund Continuous Disclosure.
25. 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. The Filer does not anticipate that the current risk rating of the Existing Fund would change if the Short Selling and Cash Borrowing Relief were granted.
26. The Filer has comprehensive risk management policies and/or procedures that address the risks associated with short selling and cash borrowing in connection with the implementation of the investment strategies of the Funds.
27. 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 Requested Relief 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 and the Fund 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 and the Fund will keep proper books and records of short sales and all assets of a Fund deposited with borrowing agents as security.
28. The Filer believes that it is in the best interests 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.
Decision
The decision of the principal regulator under the Legislation is that the Requested Relief 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 all cash borrowing by the Fund does not exceed 100% of the 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. In the case of a cash borrowing transaction, the transaction:
(a) otherwise complies with all of the cash borrowing requirements applicable to alternative mutual funds under section 2.6 and 2.6.2 of NI 81-102; and
(b) is consistent with the Fund's investment objectives and strategies.
4. The Prospectus under which securities of a Fund are offered:
(a) discloses that the Fund can sell securities short or borrow cash, as applicable, up to, and subject to, the limits described in condition 1 above; and
(b) describes the material terms of this decision.