Oak Hill Asset Management Inc. and Oak Hill AQR Delphi Long-Short Equity Fund
Headnote
National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions -- relief from section 2.9.1 of NI 81-102 to permit an alternative mutual fund to use "value at risk" (VaR) measure instead of aggregate exposure to leverage, and relief from section 2.1 of NI 81-101 to permit prospectus and fund facts disclosure to reference use of VaR methodology -- Fund to calculate VaR in a manner substantially similar to what is required European fund requirements for use of "relative VaR" methodology.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds, ss. 2.9.1 and 19.1.
National Instrument 81-101 Mutual Fund Prospectus Disclosure, ss. 2.1 and 6.1.
Form 81-101F1 Contents of Simplified Prospectus, Item 4, Instruction (4).
Form 81-101F3 Contents of Fund Facts Document, Item 3.
October 9, 2024
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 OAK HILL ASSET MANAGEMENT INC. (the Filer) AND IN THE MATTER OF OAK HILL AQR DELPHI LONG-SHORT EQUITY FUND (the Fund)
DECISION
Background
The principal regulator in the Jurisdiction has received an application from the Filer for a decision under the securities legislation of the Jurisdiction of the principal regulator (the Legislation) to grant the Fund relief (the Exemption Sought) from the following provisions:
(a) Section 2.9.1 of National Instrument 81-102 Investment Funds (NI 81-102), which limits an alternative mutual fund's aggregate exposure to cash borrowing, short selling and specified derivatives transactions to 300% of the fund's net asset value (NAV) (the Leverage Requirement); and
(b) Section 2.1 of National Instrument 81-101 Mutual Fund Prospectus Disclosure, (NI 81-101) with respect to relief from Item 4 and instruction (4) of Part B of Form 81-101F1 Contents of Simplified Prospectus (Form 81-101F1) and item 3 of Part I of Form 81- 101F3 Contents of Fund Facts Document (Form 81-101F3), which require an alternative mutual fund to disclose its maximum aggregate exposure to leverage as calculated pursuant to Section 2.9.1 of NI 81-102 (the Form Requirements).
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a dual application),
(a) the Ontario Securities Commission is the principal regulator for this application; and
(b) the Filer has provided notice that subsection 4.7(1) of Multilateral Instrument 11- 102 Passport System (MI 11-102) is intended to be relied upon in each province and territory of Canada (the Jurisdictions).
Interpretation
Terms defined in National Instrument 14-101 Definitions, MI 11-102, NI 81-101 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 and the Fund
1. The Filer is incorporated under the laws of Ontario. The Filer is registered as an investment fund manager, portfolio manager and exempt-market dealer in each of Ontario and Quebec and as a portfolio manager and exempt-market dealer in each of British Columbia, Alberta, Saskatchewan and Manitoba. The Filer's head office is in Toronto, Ontario. The Filer will be the Fund's investment fund manager and portfolio manager of the fund.
2. The Fund is a mutual fund trust organized under the laws of the Province of Ontario.
3. The Fund will be a reporting issuer subject to NI 81-102 and will be an "alternative mutual fund" as defined in that Instrument. The Fund's securities will be distributed pursuant to a simplified prospectus and fund facts prepared in accordance with Form 81-101F1 and Form 81-101F3 respectively.
4. The Filer is not in default of the securities legislation of any of the Jurisdictions.
The Sub-Advisor
5. The Filer intends to appoint AQR Capital Management, LLC (the Sub-Advisor) as portfolio Sub-Advisor for the Fund. The Sub-Advisor is a limited liability company formed in the State of Delaware and is registered with the United States Securities and Exchange Commission (SEC) as an investment adviser and with the United States Commodity Futures Trading Commission ("CFTC") as a commodity pool operator and commodity trading advisor and is a member of the U.S. National Futures Association. The Sub-Advisor will be retained by the Filer to manage the Funds' investment strategy.
6. The Sub-Advisor is not in default of the securities legislation of any of the Jurisdictions.
Relief from the Leverage Requirement
7. The investment objective of the Fund is to provide consistent long-term capital appreciation and to provide unitholders with an attractive risk-adjusted rate of return by actively investing in a portfolio comprised of long and short equity securities.
8. The Sub-Advisor intends to employ a proprietary quantitative and systematic investment strategy for the Fund that attempts to benefit from perceived short-term mispricing in various equity securities. In this context, systematic refers to the implementation of portfolio position changes derived from quantitative models which have been developed by the Sub-Advisor and are refined as part of the investment research process. The Sub-Advisor uses the models to allocate exposure on a tactical basis between the various equity securities in which the Fund may invest.
9. The Fund will be primarily managed according to the investment strategy and process that AQR has deployed as investment adviser to the AQR Sustainable Delphi Long-Short Equity UCITS Fund ("UCITS Fund"). The UCITS Fund was established on October 26,2018 and is distributed in the United Kingdom (UK) and the European Union (EU).
10. If the UCITS Fund were required to use measure its exposure to leverage in accordance with the Leverage Requirement, it would have consistently exceeded 300% of its NAV, since inception. Based on the UCITS Fund's data, its aggregate exposure leverage under the Leverage Requirement has typically ranged between 300-600% of its NAV, and have average approximately 500% since the UCITS Fund's inception.
11. Since the Fund's investment strategies will be based on and substantially similar to the UCITS Fund, the Filer anticipates that the Fund's exposure to leverage as measured under the Leverage Requirement would produce similar results and regularly exceed the 300% of NAV limit in the Leverage Requirement.
12. The Filer is instead proposing that the Fund use a value-at-risk (VaR) methodology to measure its leverage risk, similar to what the UCITS Fund uses, and as described in this decision document.
13. The Fund needs relief from the Leverage Requirement to have aggregate exposure to leverage that exceeds 300% of NAV and to use to a VaR methodology to measure the Fund's leverage risk.
Relief from the Form Requirement
14. The Form Requirement requires the Fund to disclose in its fund facts and simplified prospectus its maximum aggregate exposure to cash borrowing, short selling and specified derivatives, as measures in accordance with the Leverage Requirements.
15. The Fund needs relief from the Form Requirement in order to disclose the Fund's use of VaR to measure its leverage risk, as described in this decision document.
Generally
16. The Fund's investment strategies will use specified derivatives that will result in the Fund's aggregate exposure to cash borrowing, and specified derivatives transactions exceeding 300% Fund's NAV, but in a manner that does not expose the Fund to excessive leverage risk.
17. For strategies that deploy leverage, a VaR-based approach is a better means of managing risk because, unlike notional amounts which do not measure risk or volatility, VaR enables risk to be measured in a reasonably comparable and consistent manner. For this reason, VaR is a widely used risk measure and has been adopted in both the EU and the United States for their respective risk frameworks for retail-based funds.
18. The EU approved a regulation of mutual funds in 2010 in the fourth European Directive covering Undertakings for Collective Investment in Transferable Securities (the UCITS Framework), which introduced a VaR-based approach to regulatory risk management for investment funds that extensively use derivatives.
19. This approach allows for two methods of measuring VaR limits, "relative" (Relative VaR) and "absolute" (Absolute VaR), which in general terms can be summarized as follows:
(a) Relative VaR: This approach uses a ratio of up to 200% between the VaR of the fund's the portfolio and the VaR of a designated reference portfolio.
(b) Absolute: This approach is generally used when there is no appropriate reference portfolio or benchmark and allows the one-month VaR to be up to 20% of the net asset value of the portfolio.
20. The UCITS Framework also includes rules for the computation of VaR and requires regular stress- and back-testing to complement the VaR estimation.
21. On October 28, 2020 the SEC adopted Rule 18f-4 under the Investment Company Act of 1940, (the SEC Rule), which included a regime for using VaR to measure leverage risk that is substantially the same as the regime under the UCITS Framework including permitting the use of Relative VaR and Absolute VaR and the respective limits for each approach.
22. In addition to complying with VaR limits, both the UCITS Framework and SEC Rule require that a fund must adopt a risk management policy, which includes risk guidelines, stress testing, back testing, internal reporting and escalation, and periodic review thereof. The risk management policy addresses concerns about fund leverage for investment portfolios which utilize derivatives and deploy leverage.
23. For long-short strategies that use leverage such as the Fund, the Filer believes a VaR-based approach is a better means of managing risk because, unlike notional measures, which do not measure risk or volatility, VaR enables risk to be measured in a reasonably comparable and consistent manner.
24. Allowing the Fund to use a VaR-based methodology is a more appropriate risk framework for long-short portfolios and would give investors access to an investment product that will diversify their holdings and may result in superior non-correlated returns at critical times.
25. The Sub-Advisor has employed a VaR-based risk management framework for its UCITS Fund since its inception that conforms with the UCITS Framework and is experienced in managing strategies similar to what the Fund will be adopting. rules.
26. The Filer has determined that a Relative VaR measure will be the most suitable approach for the Fund because the Filer has been able to identify a suitable reference portfolio for the purposes of the methodology. The Filer has identified to the MSCI World Net Total Return Hedged Index in USD as the appropriate designated reference portfolio for the Fund, for the purposes of its Relative VaR calculations.
27. The Fund will otherwise comply with all the material aspects of the Relative VaR methodology as outlined in the UCITS Framework. In addition to complying with Relative VaR limits, the Filer's risk process will include regular reporting to Senior Management and to the IRC, highlighting the current level of risks relevant to the Fund, and outlining any actual or foreseeable breaches to their limits to ensure prompt and appropriate action is taken.
28. On a daily basis the Filer will produce risk reports (the Bloomberg Reports) from the Bloomberg MARS (Multi Asset Risk System) application (the Bloomberg MARS System), to confirm that the Fund is compliant with the Relative VaR test.
29. It is not consistent with the requirement to provide full, true and plain disclosure for the Fund to be required to refer to the Leverage Requirement in its Prospectus, since the Filer is not proposing to manage the Fund in accordance with that requirement.
30. The Fund's simplified prospectus and fund facts will disclose the Fund's use of Relative VaR, including the appropriate reference portfolio selected for its Relative VaR calculations.
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.
1. The decision of the Commission under the Legislation is that the Exemption Sought is granted, provided that
(a) the Filer and the Fund complies with the Relative VaR, as described in Appendix A, and complies with all of the additional leverage conditions for funds set out in Appendix A;
(b) the Filer does not change the VaR methodology that it is using with respect to the Fund;
(c) the Fund's prospectus disclosure concerning its use of VaR includes the appropriate designated reference portfolio selected for the purposes of its Relative VaR calculations;
(d) the Filer uploads the investment portfolio each business day to the Bloomberg MARS system in order to have the applicable Bloomberg Reports confirm that the Fund is compliant with the Relative VaR test;
(e) the Filer provides to the Principal Regulator on a quarterly basis a copy of each daily Bloomberg Report for the last quarter, and a copy of each report submitted to the IRC;
(f) the Filer provides to the principal regulator on a quarterly basis a copy of each daily Bloomberg Report report for the last quarter for the Fund;
(g) the Filer notifies the principal regulator within one business day if the Fund is offside the Relative VaR test for more than five consecutive business days;
(h) the Filer promptly (e.g., within 24 hours) provides the principal regulator with any other information that the principal regulator may request regarding the intermonth calculations and risk metrics the Filer is using; and
(i) the Fund's annual and interim prospectus, management report of fund performance (MRFP), and fund facts will report the range and maximum amount of relative VaR incurred by the Fund over the applicable period.
Expiration
2. This decision expires on October 9, 2028.
Application File #: 2023/0206
SEDAR+ File #: 6192990
APPENDIX A
ADDITIONAL LEVERAGE CONDITIONS
In these conditions,
"IRC", with respect to the Fund, means the fund's independent review committee ("IRC");
"derivatives risks" means the risks associated with a fund's derivatives transactions or its use of derivatives transactions, including leverage, market, counterparty, liquidity, operational, and legal risks and any other risks the derivatives risk manager deems material;
"derivatives transaction" means
(1) any swap, security-based swap, futures contract, forward contract, option, any combination of the foregoing, or any similar instrument, under which a fund is or may be required to make any payment or delivery of cash or other assets during the life of the instrument or at maturity or early termination, whether as margin or settlement payment or otherwise; and
(2) any short sale borrowing.
"designated index" means an unleveraged index that is approved by the Filer for purposes of the relative VaR test and that reflects the markets or asset classes in which the fund invests and is not administered by an organization that is an affiliated person of the fund, its investment adviser, or principal underwriter, or created at the request of the fund or its investment adviser, unless the index is widely recognized and used. In the case of a blended index, none of the indexes that compose the blended index may be administered by an organization that is an affiliated person of the fund, its investment adviser, or principal underwriter, or created at the request of the fund or its investment adviser, unless the index is widely recognized and used;
"designated reference portfolio" means a designated index;
"independent director" means a director who would be independent within the meaning of section 1.4 of National Instrument 52-110 Audit Committees;
"Relative VaR test" means that the VaR of the fund's portfolio does not exceed 200% of the VaR of the designated reference portfolio;
"value-at-risk" or "VaR" means an estimate of potential losses on an instrument or portfolio, expressed as a percentage of the value of the portfolio's assets (or net assets when computing a fund's VaR), over a specified time horizon and at a given confidence level, provided that any VaR model used by a fund for purposes of determining the fund's compliance with the relative VaR test or the absolute VaR test must:
(1) take into account and incorporate all significant, identifiable market risk factors associated with a fund's investments, including, as applicable:
(i) equity price risk, interest rate risk, credit spread risk, foreign currency risk and commodity price risk;
(ii) material risks arising from the nonlinear price characteristics of a fund's investments, including options and positions with embedded optionality; and
(iii) the sensitivity of the market value of the fund's investments to changes in volatility;
(2) use a 99% confidence level and a time horizon of 20 trading days; and
(3) be based on at least three years of historical market data.
Conditions
1. Risk management policy and program -
The fund must adopt and implement a written risk management policy, and a risk program which must include policies and procedures that are reasonably designed to manage the fund's risks and to reasonably segregate the functions associated with the program from the portfolio management of the fund. The program must include the following elements:
i. Risk identification and assessment. The program must provide for the identification and assessment of the fund's derivatives risks. This assessment must take into account the fund's derivatives transactions and other investments.
ii. Risk guidelines. The program must provide for the establishment, maintenance, and enforcement of investment, risk management, or related guidelines that provide for quantitative or otherwise measurable criteria, metrics, or thresholds of the fund's derivatives risks. These guidelines must specify levels of the given criterion, metric, or threshold that the fund does not normally expect to exceed, and measures to be taken if they are exceeded.
iii. Stress testing. The program must provide for stress testing to evaluate potential losses to the fund's portfolio in response to extreme but plausible market changes or changes in market risk factors that would have a significant adverse effect on the fund's portfolio. The frequency with which the stress testing under this paragraph is conducted must take into account the fund's strategy and investments and current market conditions, provided that these stress tests must be conducted no less frequently than weekly.
iv. Backtesting. The program must provide for backtesting to be conducted no less frequently than weekly, of the results of the VaR calculation model used by the fund in connection with the relative VaR test by comparing the fund's gain or loss that occurred on each business day during the backtesting period with the corresponding VaR calculation for that day, estimated over a one-trading day time horizon, and identifying as an exception any instance in which the fund experiences a loss exceeding the corresponding VaR calculation's estimated loss.
v. Internal reporting and escalation --
A. Internal reporting. The program must identify the circumstances under which persons responsible for portfolio management will be informed regarding the operation of the program, including exceedances of the guidelines specified in paragraph 1.ii. of these conditions and the results of the stress tests specified in paragraph 1.iii. of these conditions.
B. Escalation of material risks. The person responsible for overseeing the Filer's risk program must inform in a timely manner persons responsible for portfolio management of the fund of material risks arising from the fund's derivatives transactions, including risks identified by the fund's exceedance of a criterion, metric, or threshold provided for in the fund's risk guidelines established under paragraph 1.ii. of these conditions or by the stress testing described in paragraph 1.iii. of these conditions.
vi. Periodic review of the program. Senior Management of the Filer must review the program at least annually to evaluate the program's effectiveness and to reflect changes in risk over time. The periodic review must include a review of the VaR calculation model used by the fund under condition 2 below (including the backtesting required by paragraph 1.iv. of these conditions) and any designated reference portfolio to evaluate whether it remains appropriate.
2. Limit on fund leverage risk --
i. The fund must comply with the relative VaR test unless it is determined that the designated reference portfolio would not provide an appropriate reference portfolio for purposes of the relative VaR test, taking into account the fund's investments, investment objectives, and strategy. A fund that does not apply the relative VaR test must comply with the absolute VaR test.
ii. The fund must determine its compliance with the applicable VaR test at least once each business day. If the fund determines that it is not in compliance with the applicable VaR test, the fund must come back into compliance promptly after such determination, in a manner that is in the best interests of the fund and its securityholders.
3. Board oversight and reporting --
i. Regular board reporting. The Filer must provide to the IRC, annually or at such other frequency determined by the board, a written report regarding the Filer's analysis of exceedances described in paragraph 1. ii. of these conditions. Each report under this paragraph must include such information as may be reasonably necessary for the board to evaluate the fund's response to exceedances.
4. Recordkeeping --
i. Records to be maintained and Retention Periods. A fund must maintain all records and materials that paragraphs 1. and 2. of these conditions describe for a period of not less than seven years (the first two years in an easily accessible place) following each determination, action, or review that these paragraphs describe.