YTM Capital Asset Management Ltd. and YTM Capital Fixed Income Alternative 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 an alternative mutual fund to short sell “government securities”, as defined in NI 81-102, up to 300% of NAV – relief sought in order to short securities in connection with fund’s hedging strategy – features of government bonds mitigate many of the risks associated with short selling strategies – relief also granted to future alternative mutual funds managed by the Filer with similar short selling strategies.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds – ss. 2.6.1, 2.6.2, 19.1.
May 21, 2019
IN THE MATTER OF
THE SECURITIES LEGISLATION OF
IN THE MATTER OF
THE PROCESS FOR EXEMPTIVE RELIEF APPLICATIONS
IN MULTIPLE JURISDICTIONS
IN THE MATTER OF
YTM CAPITAL ASSET MANAGEMENT LTD.
IN THE MATTER OF
YTM CAPITAL FIXED INCOME ALTERNATIVE FUND
(the Initial Fund)
The principal regulator in the Jurisdiction has received an application from the Filer on behalf of the Initial Fund for a decision under the securities legislation of the Jurisdiction of the principal regulator (the Legislation) exempting the Initial Fund and any alternative mutual funds established in the future for which the Filer or an affiliate of the Filer acts as investment fund manager and which employ short selling strategies similar to the Initial Fund (the Future Funds and together with the Initial Fund, the Funds or individually, a Fund) from the following provisions of National Instrument 81-102 Investment Funds (NI 81-102) in order to permit the Fund to short sell “government securities” as that term is defined in NI 81-102, up to a maximum of 300% of a Fund’s net asset value (NAV) (the Exemption Sought):
(a) subparagraph 2.6.1(1)(c)(v) of NI 81-102, which restricts the Funds 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 Funds’ NAV; and
(b) section 2.6.2 of NI 81-102, which states that the Funds may not borrow cash or sell securities short if, immediately after entering into a cash borrowing or short selling transactions, the aggregate value of cash borrowing combined with the aggregate market value of the securities sold short by the Funds would exceed 50% of the Funds’ 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 paragraph 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in each of British Columbia, Alberta, Saskatchewan, Manitoba, Quebec, New Brunswick, Nova Scotia, Prince Edward Island, Newfoundland and Labrador, Northwest Territories, Yukon and Nunavut (the Other Jurisdictions and with the Jurisdiction, the Jurisdictions).
Terms defined in National Instrument 14-101 Definitions and MI 11-102 have the same meaning if used in this decision, unless otherwise defined.
The decision is based on the following facts represented by the Filer on behalf of itself and the Fund:
1. The Filer is a corporation established under the laws of Canada. The Filer’s head office is located in Oakville, Ontario.
2. The Filer is the investment fund manager, trustee and portfolio manager of the Initial Fund. The Filer, or an affiliate, will be the investment fund manager and portfolio manager of the Future Funds. The Filer also acts as the investment fund manager and portfolio manager of an investment fund, the YTM Capital Credit Opportunities Fund (CCOF), the securities of which are sold pursuant to exemptions from applicable prospectus requirements in securities legislation.
3. The Filer is registered as an investment fund manager in Ontario, Quebec and Newfoundland and Labrador, as a portfolio manager in Ontario, and as an exempt market dealer in Ontario.
4. The Filer is not in default of applicable securities legislation in any of the Jurisdictions.
5. The Funds are or will be open-ended public alternative mutual funds governed by NI 81-102.
6. The Funds are or will be organized as trusts established under the laws of the Province of Ontario.
7. The Funds will distribute units in each of the Jurisdictions pursuant to a simplified prospectus, annual information form and fund facts, prepared and filed in accordance with National Instrument 81-101 Mutual Fund Prospectus Disclosure.
8. The Initial Fund is not in default of applicable securities legislation in any of the Jurisdictions.
9. The Initial Fund’s investment objective is to seek to provide maximum risk adjusted returns over the long term and to preserve capital, by investing primarily in fixed-income securities, cash, and by entering into derivatives arrangements. It will use alternative strategies including engaging in physical short sales, cash borrowing for investment purposes, and using derivatives, in the process creating leverage. The maximum aggregate exposure created by leverage is 300% of the Fund’s net asset value, unless otherwise permitted by securities legislation.
The Short Hedging Strategy
10. In order to hedge against interest rate risk in the Initial Fund and isolate levered corporate credit exposure, the Initial Fund proposes to short sell liquid government fixed income securities at the same time that the Initial Fund invests in corporate fixed income securities (the Short Hedging Strategy). The Short Hedging Strategy is effective because there a high degree of correlation between the movement of government and corporate fixed income securities caused by changes in interest rates, creating a hedge against losses in value of the long corporate position. This relationship is a fundamental part of the fixed-income market such that dealers quote the price of corporate bond based on the incremental yield of the corporate bond over an equivalent term government bond.
11. The Filer believes that the Short Hedging Strategy provides investors with the potential for low volatility and compelling returns. A similar strategy has proven to be highly successful with CCOF.
12. The Short Selling Restrictions would restrict the Initial Fund to short selling government fixed income securities to no more than 50% of the Fund’s NAV. However, NI 81-102 would permit the Initial Fund to obtain the additional leveraged short exposure through the use of specified derivatives, up to an aggregate exposure of 300% of the Fund’s NAV.
13. The Filer is of the view however, 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 forced to achieve that degree of leverage through either specified derivatives alone, or a combination of physical short selling and specified derivatives, 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.
14. The Future Funds will employ an investment strategy similar to the Short Hedging Strategy in that each will contemplate short-selling government securities concurrently with investing in long positions in corporate fixed income securities.
15. The only securities sold short by the Funds in excess of 50% of a Fund’s NAV will be “government securities” as that term is defined in NI 81-102. The Funds will otherwise comply with the provisions governing short selling by an alternative mutual fund under sections 2.6.1 and 2.6.2 of NI 81-102.
16. Each Fund’s aggregate exposure to short selling, cash borrowing and specified derivatives will not exceed 300% of the Fund’s NAV, in compliance with section 2.9.1 of NI 81-102 (the Aggregate Leverage Limit).
17. The Funds 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.
18. Each Fund’s prospectus (the Prospectus) will contain adequate disclosure of the Fund’s short selling activities, including the material terms of the Exemption Sought.
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. 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. The Fund’s Prospectus will disclose 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.
Investment Funds and Structured Products Branch
Ontario Securities Commission