Canadian Mutual Funds Readying to Launch Liquid Alternatives

Canadian Mutual Funds Readying to Launch Liquid Alternatives

Scotiabank recently released what it calls a “high-level guide for mutual fund companies interested in launching liquid alternative products.”

The creation of this guide was stimulated by a reform of the regulations of the Canadian Securities Administrators, aimed at making liquid alternatives more readily available to investors in Canada. On October 4, 2018, the CSA issued the Modernization of Investment Fund Product Regulation—Alternative Mutual Funds.

The mass retail market in Canada is dominated by 15 large institutions that together control approximately 95% of the mutual fund space.

Scotiabank expects that “traditional mutual fund managers will be interested in diversifying the investment solutions on their shelf by adding liquid alts to their product line-up.”

The paper observes that in the U.S., a modernization of fund regulations in 2013 helped propel the assets under management (AUM) number for liquid alts. The AUM for these products was $225 billion by 2017. The U.S. market is 10 times the size of Canada’s. But accounting for the scale, this neighboring example suggests that the liquid alts market there could grow by C$20 billion over the next five years.

Let us take an inventory of some of what the new CSA regulation does:

  • Permits higher leverage on the part of mutual funds—up to 300% of net asset value;
  • Permits greater use of short positions—up to 50% of NAV with a 10% single issuer limit;
  • Permits alternative mutual funds to charge performance fees that are not linked to the performance of a benchmark or index;
  • Increases concentration limits;
  • Limits illiquid assets to just 10% of the NAV after purchase;
  • Require calculation of NAV daily; and
  • Allow liquid alts to invest 100% of their NAVs in other funds.

These rules are expected to come into force on Jan. 3, 2019.

Long-only managers are not likely to have developed a relation with a prime broker. Those mutual funds who want to move into the liquid alternatives space will need to be brought up to speed on what a prime broker does, since this will be a new element in their business model.

Scotiabank offers a short primer on prime brokerage in this paper. A prime broker facilitates short positions, provides margin financing on long assets, acts as a derivative financing counterparty to swap transactions for equity and credit exposure; clears and settles trades; and services assets—for example, by processing corporate dividends.

Relations between a fund (hedge or alt-oriented mutual) on the one hand, and a prime broker on the other can follow one of two models. There is a cash model (the fund holds or shorts securities directly in the physical market) and there is a synthetic model (derivatives replicate the performance of the underlying security.) Each model has, Scotiabank observes, “pros and cons,” and a prospective prime broker should be able to speak to this question.

The paper also provides some tips for mutual fund firms that are hiring prime brokers. One of these concerns the balance sheet. “A prime broker needs to have sufficient funding resources and an appetite to finance a fund’s portfolio,” it observes, and “certain types of trades and assets place a greater strain on a prime broker’s balance sheet and regulatory capital, which are both finite resources [than others].”

Operational Issues

The paper further discusses certain operational issues that arise within the fund/prime broker relationship. For example, the latter will need to create for itself an automated process to secure stock loan locates from the former.

Important operational reports are available daily from a prime broker. These include: the stock loan billing report, a daily accrual of stock borrowing fees; the financing report, a daily accrual of long and short financing; and the margin report, a daily mark-to-market of loan value and margin requirement.

Mutual funds that are considering a move into the alternative space should also consider their relationship with their dealer. The paper says, “Dealers tend to have more detailed processes in place for adding alternative funds to their product shelf—processes that include due diligence on the manager, the strategy and the fund, as well as benchmarking. At the end of the process, many alternative funds receive a ‘high risk’ rating that limits the level of investment by advisors.”

Lest some of this detail seem daunting, the report ends on a sunny note. “The opportunity for liquid alts in Canada is truly compelling…. Industry players who are flexible and proactive in rising to this challenge will be well positioned to capture the significant opportunity at hand.”

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