RBC Global Asset Management Inc. (Re), 2022 CanLII 114852

November 04, 2022

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

RBC GLOBAL ASSET MANAGEMENT INC. (the Filer) and the existing and future mutual funds that are not alternative mutual funds for which the Filer or an affiliate acts, or will act, as the investment fund manager (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) under section 19.1 of National Instrument 81-102 Investment Funds (NI 81-102) exempting a Fund from the cash cover requirements in section 2.8(1)(d) of NI 81-102 (the Cash Cover Requirements) in respect of opening and maintaining the long derivatives positions referenced in (a)(ii) and (b)(ii) below when, as part of the Cross Hedging Strategies defined as follows and further described in this decision:

(a) in order to hedge the Fund’s exposure to the interest rate of government bonds issued by the sovereign for the currency in which corporate bonds held directly or indirectly by the Fund (the Corporate Bond Holding) are denominated, such as USD, AUD, EUR, JPY, GBP or CAD, (each an Original Currency) into exposure to the interest rate of government bonds issued by the sovereign of a different selected currency (each a Selected Currency), the Fund enters into (i) a short derivatives position in respect of government bonds issued by the sovereign for the Original Currency and (ii) a corresponding long derivatives position in respect of government bonds issued by the sovereign for the Selected Currency (Government Bond Rate Cross Hedging); and

(b) in order to hedge the Fund's exposure to an equity index that is linked or correlated to the Fund's direct or indirect investment in a basket of equities (the Equity Basket) (the Original Index) into exposure to a different selected equity index (the Selected Index), the Fund enters into (i) a short derivatives position in respect of the Original Index and (ii) a corresponding long derivatives position in respect of the Selected Index (Equity Cross-Market Hedging and, together with Government Bond Rate Cross Hedging, the Cross Hedging Strategies)

(The Requested Relief). Each of the short and long derivatives positions referenced above in (a)(i) and (b)(i), and in (a)(ii) and (b)(ii), are referred to below as a Short Derivatives Position and Long Derivatives Position respectively.

Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):

(a) the Ontario Securities Commission is the principal regulator for this application; and

(b) the Filer has provided notice that section 4.7(1) of Multilateral Instrument 11-102 - Passport System (MI 11-102) is intended to be relied upon in British Columbia, Alberta, Saskatchewan, Manitoba, Québec, New Brunswick, Nova Scotia, Prince Edward Island, Newfoundland and Labrador, the Northwest Territories, Nunavut and Yukon (together with the Jurisdiction, the Jurisdictions).

Interpretation

Terms defined in National Instrument 14-101 – Definitions, MI 11-102 and NI 81-102 have the same meaning if used in this decision, unless otherwise defined.

Representations

This decision is based on the following facts represented by the Filer.

The Filer

1. The Filer is a corporation formed by amalgamation pursuant to articles of amalgamation dated November 1, 2013 under the federal laws of Canada and its head office is located in Toronto, Ontario.

2. The Filer is an indirect, wholly-owned subsidiary of Royal Bank of Canada.

3. The Filer is registered as an adviser in the category of portfolio manager and as a dealer in the category of exempt market dealer under the securities legislation of each Jurisdiction, is registered as an investment fund manager in each of British Columbia, Ontario, Québec and Newfoundland and Labrador and is also registered in Ontario as a commodity trading manager.

4. The Filer, or an affiliate, is or will be, the investment fund manager of each Fund. The Filer, or an affiliate, will also be the registered portfolio manager of each Fund.

5. The Filer is not in default of any of its obligations under securities legislation of any Jurisdiction.

The Funds

6. Each Fund is, or will be, a conventional mutual fund or an exchange-traded fund established under the laws of the Province of Ontario or the laws of another Province of Canada or under Canadian federal law.

7. Each Fund is, or will be, subject to NI 81-102, subject to any exemptions that may be granted by the securities regulatory authorities. No Fund will be an alternative mutual fund.

8. The securities of the Funds are, or will be, offered either by a simplified prospectus and annual information form or long-form prospectus, as applicable, filed in all of the Jurisdictions and, accordingly, each Fund is, or will be, a reporting issuer in the Jurisdictions.

9. None of the Funds in existence on the date of this decision is in default of any of their obligations under the securities legislation of any Jurisdiction.

10. The Funds are, or will be, permitted to use specified derivatives to reduce risk by hedging against losses caused by changes in securities prices, foreign currency exposure, interest rates and government bond rates for different currencies, exchange rates and/or other risks. The Funds may also use specified derivatives for non-hedging purposes pursuant to their investment strategies in order to gain exposure to interest rates and government bond rates for different currencies, and to equities or benchmark equity indexes, provided the use of specified derivatives is consistent with the relevant Fund's investment objectives.

11. Any Fund that is not currently permitted to engage in the use of derivatives will only do so in accordance with Section 2.11 of NI 81-102.

12. In all cases where the Funds may use derivatives, hedging of risks is permitted, including for interest rate risks for different currencies, equity investment risks or otherwise.

13. When specified derivatives are used for non-hedging purposes, the Funds are subject to the Cash Cover Requirements, subject to applicable exemptive relief.

Government Bond Rate Cross Hedging

14. Government Bond Rate Cross Hedging will enable a Fund to substitute the Fund’s exposure to the government bond rate of the sovereign for the Original Currency with a corresponding exposure to the government bond rate of the sovereign for the Selected Currency. Reference in this decision to the sovereign includes reference to a central bank or central government as the relevant sovereign issuer of government bonds.

15. The need to conduct Government Bond Rate Cross Hedging arises as a result of corporate bonds generally trading based on a spread to government bonds issued by the sovereign for the currency in which the corporate bonds are denominated. For example, individual USD-denominated corporate bonds tend to trade based on a spread to United States Treasury securities having a comparable tenor. Due to this relationship, increases in corporate bond investments denominated in an Original Currency will skew a Fund’s rate exposures to provide a potentially undesirable concentration of exposure to the government bond rates of the sovereign for the Original Currency. In many cases, the Fund’s manager would prefer to hedge away this concentration and replace this exposure with exposure to the government bond rates of the sovereign for the (different) Selected Currency.

16. Futures contracts or substantially similar OTC derivatives agreements may be entered into by a Fund in connection with corporate bond investments in order to achieve this objective and reverse the skewing of government bond rate exposures arising from corporate bond investments while maintaining a substantially equivalent level of market exposure (including issuer exposure) and sovereign bond exposure.

17. The Requested Relief will permit the Filer to manage currency risk and government bond rate exposure separately from the selection of an appropriate pool of corporate bond investments to best meet the Fund’s investment objectives.

18. Accordingly, the Filer seeks the ability for any Fund to enter into Government Bond Rate Cross Hedging without being subject to the Cash Cover Requirements, subject to the conditions of this decision set out below.

Equity Cross-Market Hedging

19. The Filer has identified benefits which can arise if the Filer is permitted to efficiently re-configure its direct or indirect (including through investments in other investment funds) exposure to an Equity Basket by balancing a short position taken in an Original Index identified as linked or correlated to the Equity Basket with a corresponding long position taken in a (different) Selected Index.

20. This management strategy is an important tool if the portfolio manager is satisfied with the relative values of the individual equity positions in the Equity Basket held at a particular time but also wishes to reduce overall exposure to the equity market underlying the Equity Basket due to an expectation that the relevant equity market as a whole is over-priced compared to another equity market.

21. For example, if a Fund holds an Equity Basket of selected investments in particular large-capitalization U.S. corporate equities that are mostly included in the S&P 500 and that the manager considers desirable based on their current prices vs. alternate U.S. corporate equity investments, but the manager considers that U.S. equity markets are generally over-priced compared to Canadian equity investments, then the Requested Relief would permit the manager to continue to hold this Equity Basket but efficiently reduce the Fund’s exposure to U.S. equities by at the same time entering into derivatives transactions (which may be futures contract or OTC derivatives transactions) (a) to short the S&P 500 and (b) to take a long position in the S&P/TSX 60 in an equivalent notional amount.

22. In this example, the resulting net investment exposure of the Fund directly corresponds to the original investment in the Equity Basket, but exposure to the relevant underlying U.S. large-cap equity market is replaced by exposure to the relevant Canadian large-cap equity market (including growth, interest rate and inflation expectations). Accordingly, the Requested Relief would permit the portfolio manager to efficiently manage a Fund’s exposures to different countries’ equity markets separately from the selection of an appropriate pool of individual equity investments (and without requiring significant rebalancings, sales and repurchases of individual portfolio holdings) in order to best meet the Fund’s investment objectives.

23. The Requested Relief will permit the Filer to quickly and efficiently rebalance its exposures to different equity markets in a manner which does not increase overall market exposure for the relevant Funds. The Filer believes that this will provide important liquidity, pricing, depth of market and diversification benefits for Fund investors.

24. Accordingly, the Filer seeks the ability for any Fund to enter into Equity Cross-Market Hedging without being subject to the Cash Cover Requirements subject to the conditions of this decision set out below.

Regulatory Framework

25. Section 2.8(1)(d) requires mutual funds (other than alternative mutual funds) to hold cash cover when opening or maintaining a long position in a standardized future or forward contract, in an amount that, together with margin on account for the specified derivative and the market value of the specified derivative, is not less than, on a daily mark-to-market basis, the underlying market exposure of the specified derivative.

26. Section 2.9 of NI 81-102 provides an exception to section 2.8 for the use of specified derivatives by a mutual fund for hedging purposes. However, the Filer submits that the definition of “hedging” in NI 81-102 would not capture the Long Derivatives Position taken as part of the Cross Hedging Strategies.

27. Similarly, while the definition of “cash cover” in NI 81-102 includes as “synthetic cash” a long position in a portfolio of shares and a short position in a standardized future of which the underlying interest consists of a stock index (subject to conditions), the Filer submits that the definition of “synthetic cash” in NI 81-102 would not capture the range of Equity Cross-Market Hedging contemplated by the Filer. In particular, for example, the Filer wishes to have the flexibility (a) to use both futures and over-the-counter (OTC) derivatives for Equity Cross-Market Hedging whereas the definition of “synthetic cash” in NI 81-102 refers only to using standardized futures, and (b) to use Equity Cross-Market Hedging to reconfigure exposures where all or part of the Equity Basket is indirectly held by a Fund by virtue of its investment in another Fund, which is not expressly contemplated the definition of “synthetic cash” in NI 81-102.

28. The purpose of the Cash Cover Requirements in Section 2.8(1)(d) of NI 81-102 is to prohibit a mutual fund from obtaining leveraged exposure to portfolio assets when using certain derivatives other than for hedging purposes (within the definition of “hedging” in NI 81-102). Generally, any exposure to investment positions using derivatives that do not constitute a hedge as contemplated under NI 81-102 triggers an obligation to hold an equivalent amount of cash cover in order to ensure that conventional mutual funds do not improperly use leverage that can increase volatility and positive and negative returns in a manner that is not appropriate for such funds.

29. The Filer considers that Government Bond Rate Cross Hedging and Equity Cross-Market Hedging will not increase leverage in the Funds in the manner that the Cash Cover Requirements are intended to address. Instead, they will replace an ordinary exposure to one underlying benchmark (i.e., exposure to government bond rates in the Original Currency or to an equity market index) with exposure to a comparable substitute benchmark (i.e., exposure to government bond rates in a replacement currency or another equity market index) which the Fund’s portfolio manager will determine in the appropriate circumstances is the preferred investment exposure.

Additional Matters

30. The Filer has developed a number of policies and mechanisms to monitor the use of derivatives by the Funds in order to comply with the requirements in NI 81-102 and related exemptive relief.

31. In addition, the Filer has written control policies and procedures that set out the risk management procedures applicable to derivative transactions, including futures contracts, for the Funds. These set out specific procedures for authorization, documentation, reporting and monitoring of each Fund's derivative transactions. Monitoring will be adopted in connection with the Requested Relief (a) to ensure the Fund’s corresponding Short Derivatives Position and Long Derivatives Position have matching tenors (or the corresponding long position will be closed out if the short position is no longer in effect) and matching notional amounts and (b) to otherwise ensure compliance with the conditions of this decision.

32. Furthermore, the Filer's review of compliance with such policies and procedures shall be performed by individuals independent of those who trade on behalf of the Funds. These independent personnel employed by the Filer (and any sub-advisor appointed by the Filer, if applicable) routinely review the use of derivatives and compliance with NI 81-102 as part of their ongoing supervision of Funds' investment practices and investment exposures.

33. Permitting individual Funds to enter into derivatives contracts in order to engage in Government Bond Rate Cross Hedging and/or Equity Cross-Market Hedging without the requirement to comply with the Cash Cover Requirements will provide the Funds with better opportunities to efficiently pursue and achieve their investment objectives.

34. The Filer believes that the Requested Relief is in the best interests of the Funds as it allows efficient active management of portfolio assets consistent with their investment objectives, and will permit efficient price-sensitive hedging of underlying government bond rates and benchmark equity market exposures into selected replacement government bond rates and alternate benchmark equity market exposures without introducing increased portfolio leveraging of the type which Section 2.8(1)(d) of NI 81-102 was intended to address.

35. The Filer is seeking the Requested Relief to permit the Funds to engage in strategies that are otherwise permitted under NI 81-102.

Decision

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 is that the Requested Relief is granted provided that where a Fund relies on the Requested Relief:

(a) the use of Government Bond Rate Cross Hedging and/or Equity Cross-Market Hedging as contemplated by this decision is consistent with the fundamental investment objectives and investment strategies of the applicable Fund;

(b) the opening and maintenance of each Short Derivatives Position meets the definition of “hedging” in NI 81-102 in respect of a corresponding Corporate Bond Holding, in the case of Government Bond Rate Cross Hedging, or in respect of a corresponding Equity Basket, in the case of Equity Cross-Market Hedging;

(c) if all or a portion of a Short Derivatives Position terminates or is closed out, then an equivalent portion of its corresponding Long Derivatives Position must also terminate or be closed out;

(d) subject to condition (e), the Fund will not open or maintain a Long Derivatives Position unless the underlying market exposure to the Fund of all of its Long Derivatives Positions (the Long Derivatives Exposure) would not exceed, on a daily mark-to-market basis, the aggregate of the market value of its corresponding:

(i) Short Derivatives Positions;

(ii) Corporate Bond Holdings, in the case of Government Bond Rate Cross Hedging, or Equity Baskets, in the case of Equity Cross-Market Hedging; and

(iii) Long Derivatives Positions (the Aggregate Amount); and

(e) if its Long Derivatives Exposure exceeds at any time the Aggregate Amount referenced in condition (d) above, then the Fund must, as quickly as is commercially reasonable, take all necessary steps to reduce its Long Derivatives Exposure, or allocate additional cash cover or margin on account so that its Long Derivatives Exposure does not exceed the Aggregate Amount and allocated cash cover and margin on account.

"Darren McKall"

Darren McKall, Manager, Investment Funds & Structured Products Branch Ontario Securities Commission

Application No. 2021/0016