17.6.2 Mutual Fund Restrictions

Mutual Fund Restrictions

A mutual fund’s manager provides day-to-day supervision of the fund’s investment portfolio. In trading the fund’s securities, the manager must observe several guidelines specified in the fund’s charter and prospectus, along with constraints imposed by provincial securities commissions.

Restrictions on Mutual Fund Management Practices

The management of a mutual fund portfolio involves adherence to a variety of restrictions, which vary from fund to fund. Here are some common limitations:

• Issuer Proportion: Purchases limited to no more than 10% of the total securities of a single issuer or more than 10% of a company’s voting stock.
• Manager’s Own Company: No investment in the shares of the manager’s own company (e.g., a bank-owned fund cannot buy shares in that bank).
• Net Asset Allocation: No more than 10% of the net assets in securities of a single issuer or 20% in companies within the same industry, save for specialty funds.
• Other Mutual Funds: No purchases in other mutual funds unless there is no duplication of management fees.
• Leverage Prohibited: No borrowing for leverage purposes.
• Margin Buying/Short Selling: Strict no to margin buying or short selling.
• Commodities and Futures: No commodity or commodity futures purchases.
• Illiquid Securities : Limits on holdings in illiquid securities such as private placements or unlisted stocks.

Use of Derivatives

Mutual fund managers are tightly regulated with respect to derivatives—financial contracts whose value hinges on underlying assets like commodities, stocks, bonds, or indices. Allowed derivatives include options (puts and calls), futures, forwards, rights, warrants, and combination products.

Common Uses of Derivatives

• Hedging: Mitigating risk through instruments like put options.
• Facilitating Market Entry/Exit: Utilizing derivatives to manage market participation efficiency.

Example

A fund manager concerned about a potential market decline could purchase put options on the iUnits S&P/TSX 60 Index Fund (i60s). If the market dips, the loss in portfolio value would be countered by gains in the put options.

Regulatory Controls

Derivatives regulations include:

• Investment Cap: Max 10% of net assets in derivatives.
• Hedging Requirement: Derivatives positions must be hedged according to daily valuations of fund assets.
• Expiry Dates: Specific terms for options and futures.
• Professional Qualifications: Detailed advisor qualifications to trade.

Exempted from these rules are hedge funds and alternative mutual funds. These products, detailed in later chapters, allowed speculated by leveraged derivatives.

Prohibited Selling Practices

Certain practices are forbidden to ensure ethical conduct:

• Future Price Predictions: Quoting future or back-dated prices is unlawful.
• Repurchase Offers: Pledging to repurchase to shield clients from price drops is banned; normal redemption rights persist.
• Licensing and Registration: Selling without appropriate licensing or handling unauthorized securities is illegal.
• Advertising Registration: Implies unsanctioned regulatory approval, hence prohibited.

Any promotional activities must comply entirely with NI 81-102 and NI 81-105.

Guidelines and Restrictions

Broad guidelines aim to regulate fund management behavior with clear dos and don’ts, including commission changes, subsidizing expenses, and providing non-significant gifts.

Sales Communications

Any form of communication (written, oral, or advertising) must be honest and rigorous, ensuring transparency and comprehensive disclosure. No misleading information or unproven performance claims are allowed.

Communicating Rates of Return

All performance communications must abide by industry standards like time-weighted or dollar-weighted returns approved by the Global Investment Performance Standards.

Performance Reporting Requirements

Under MFDA rule 5.3.4, annual reports detailing asset market values, deposits, withdrawals, and percentage returns must be provided to clients.

Key Takeaways

• Mutual fund managers follow strict guidelines on portfolio composition and conduct.
• The use of derivatives by mutual funds is regulated with detailed restrictions on their purposes and limits.
• Prohibited practices in sales and promotion exist to ensure ethical standards.
• Comprehensive and transparent communication about performance and rates of return are mandatory to protect investor interests.

Glossary

• Net Asset Value per Share (NAVPS): The value of a mutual fund’s assets minus its liabilities, divided by the number of shares outstanding.
• Put/Cash Options: Financial instruments granting the holder the right to sell (put) or buy (call) an underlying asset.
• Illiquid Securities: Securities that cannot be quickly sold without significantly affecting their price.

Frequently Asked Questions (FAQs)

Q1: What are the primary reasons for restrictions on mutual fund managers? A: To protect investors by ensuring diversified and ethical investment practices.

Q2: Can mutual funds use derivatives for speculation? A: Generally no; regulations mandate derivative use primarily for hedging and market transition, except for alternative mutual funds and hedge funds.

Q3: When are mutual fund performance reports shared with clients? A: Minimally, once per year, covering at least a 12-month period.