New Alternative Funds categories now clearly defined

June 3, 2019

When I last wrote about alternative mutual funds, changes to the National Instruments were being finalized, and there were still many questions about how the sector would take shape. Since then, investors across the country have had a chance to familiarize themselves with the new regulations. Most recently, the Canadian Investment Funds Standards Committee (CIFSC) has created a new set of categories to classify alternative mutual funds. While the sector is still new, these developments have given investors a much clearer picture of what to expect.

It is helpful to start with a review of some of the key new rules that affect alternative funds, because they specify what types of investments are permitted and ultimately whether a particular alternative strategy is feasible.

These rules are presented with respect to alternative mutual funds. In most cases, the previous limits still apply to conventional mutual funds.

What has changed?

* Increased concentration limit: may invest up to 20% of net asset value (NAV) in one issuer.

* Increased short sales and borrowing: maximum total exposure of 50 % of NAV, includes up to 50% sold short and 50 % cash borrowed;

* Increased derivatives and total leverage: maximum total exposure of 300% of NAV, includes up to 300% in derivatives and up to 50% sold short or cash borrowed.

* Increased investment options: may invest in precious metals, commodities and related derivatives;

* Liquidity requirements: may redeem units at a price determined up to two business days after receipt of the order (must be disclosed in prospectus).

What remains the same?

* Restrictions on alternative assets: may not invest in real property and non-guaranteed mortgages or invest in guaranteed mortgages if they will be greater than 10% of NAV, and may not lend cash or portfolio assets;

* Restrictions on illiquid assets: may not invest in illiquid assets if they will be greater 10 % of NAV and must not hold illiquid assets if they will be greater than 15% of NAV for more than 90 days.

A light in the dark

As with the existing category groups, the CIFSC’s goal with Alternative Funds was to provide investors with a comprehensive set of definitions that group funds with similar mandates and risk and return profiles. Part of the challenge with defining categories is the range of strategies and asset classes that are available to alternative mutual funds. Even within a particular strategy, funds may have significant variations that make them seem as different as they are alike. The committee ultimately decided to structure and name the new categories based on four broadly distinct types of strategy: Alternative Equity Focused, Alternative Credit Focused, Alternative Market Neutral and Alternative Multi-strategy. A fifth category, Alternative Other, is reserved for funds with a unique strategy that does not fit within one of the other categories.

The table below shows how the individual strategies identified in my previous article fit within the CIFSC Alternative Funds framework and provides some insight into the committee’s rationale. (Please refer to the table in my previous article for a description of each strategy.)

In reality, classifying alternative funds is far more challenging because the distinction between strategies may be unclear. Many alternative funds allocate a portion of their portfolios to secondary strategies or asset classes and use derivatives to gain exposure to assets, which misrepresents their true exposure when derived from market values alone.

The differences between the two sets of categories highlights the additional complexity investors face when selecting alternative investments. Should funds be evaluated based on asset class, irrespective of strategy – or based on strategy, irrespective of asset class? The strategies on the left-hand side of the table are entirely segregated along the lines of the former. In the end, the CIFSC opted for a mix of the two. It makes sense when we recall that the goal of categorization in the first place is to group funds with similar risk and return profiles. Although two funds may both employ a long/short strategy, for example, if one invests in equities and the other in fixed income, then they will have very different risk profiles.

What lies ahead?

On the other hand, a specific type of strategy with a distinct risk profile that is relatively independent of its underlying assets may warrant its own category, as in the case of Alternative Market Neutral. The committee clearly felt that this would be the most prevalent type of asset-independent strategy. There are others, however, including “Arbitrage” and “Event Driven” that currently fall under “Alternative Other” and may be future candidates for categories of their own.

Unfortunately, what investors are unlikely to see are mandates focused on “alternative assets,” primarily because they consist of prohibited and illiquid assets. As noted above, with the exception of commodity-related securities, these assets are still subject to significant restrictions and concentration limits. Even if concentrated positions in illiquid assets were permitted, difficulties with valuing and disposing of investments like private debt, equity and real estate would make offering redemptions within two business days unfeasible.

Given the range of investment options available in the alternative investment sector, the CIFSC categories will help to identify funds with similar characteristics. However, prudent investors will need to carefully examine holdings and returns before deciding if a fund is suitable for their portfolio. As more information becomes available on specific alternative mutual funds, there will certainly be cause to revisit this topic in the future.

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