The Canadian Securities Administrators’ (CSA) initiative to modernize mutual fund rules and expand retail investors’ access to “alternative” investment strategies is facing opposition from the Toronto-based Canadian Foundation for Advancement of Investor Rights (FAIR Canada), which argues that investor protection must be toughened first.

The CSA published its latest version of a set of proposed reforms to the mutual fund product rules this past autumn that would expand retail clients’ access to alternative strategies, which typically are available only to wealthier investors in the exempt market. The 90-day comment period for the proposals closed at the end of 2016.

In general, both conventional investment fund firms and alternative investment portfolio managers support the initiative. Although the comments on the proposals set out a variety of concerns with the details of the new regime (such as the limits proposed for leverage and short-selling), they generally favour the regulators’ efforts to modernize the rules in this arena and potentially expand the market for alternative strategies.

For example, the comment from the Canadian chapter of the Alternative Investment Management Association Ltd. (AIMA Canada) “strongly supports” the regulators’ initiative: “Overall, the CSA has made a highly commendable effort in striking the appropriate balance among the investment restrictions, disclosure requirements and proposed distribution channels for alternative funds.”

Toughen protection first

Yet, FAIR Canada’s comment is not as welcoming. The group’s submission argues that regulators must significantly toughen investor protection before permitting ordinary retail clients access to more complex products, such as alternative investment funds.

A regulatory “best interest” standard, a ban on embedded commissions and more stringent proficiency requirements for financial advisors should be implemented before rule changes that bring alternative investment strategies to conventional mutual fund investors, according to FAIR Canada’s comment: “FAIR Canada is of the view that while there may be some demand for alternative funds by retail investors, this initiative is largely driven by the industry’s desire to generate more fees. These funds will be mostly sold by financial advisors rather than bought by retail investors. Accordingly, we are opposed to the new framework that would give retail investors ‘access’ to these funds until a statutory best interest standard is implemented and advisor proficiency is increased.”

Moreover, FAIR Canada’s submission states, there’s no evidence ordinary retail investors will benefit from increased access to alternative strategies. The comment notes that alternative funds, such as hedge funds, historically have been seen as too risky for retail investors because those portfolios typically engage in more complex strategies than do conventional mutual funds and that alternative investments’ approach also can limit their liquidity.

As a result, the investor market for these products historically has been either large institutional investors that don’t need daily liquidity and so-called “sophisticated” investors who have the financial resources to absorb potential losses on these funds and the ability to obtain expert advice on these products.

The CSA’s proposal would change the playing field dramatically by bringing alternative funds within the mutual fund tent, which would allow both investment dealers and mutual fund dealers to sell these products to their clients. The regulators acknowledge this step would require additional training – for mutual fund reps, at least. (The CSA is not proposing additional training for investment dealers’ reps.)

Earlier version

Although an earlier version of the proposal would have incorporated proficiency requirements into the CSA’s rules, this latest edition indicates that regulators have decided that the Mutual Fund Dealers Association of Canada (MFDA) should establish these requirements. The CSA proposal also states the regulators will work on establishing these requirements with the MFDA in parallel with the reforms to the product rules.

The comment from the Toronto-based Canadian Securities Institute (CSI), the securities industry’s education provider, suggests that training for mutual fund reps regarding alternative funds should be offered as an add-on to their basic proficiency standards and not as part of their standard training. The CSI comment points out that many mutual fund reps, such as bank branch-based advisors, probably won’t be permitted to sell alternative funds by their firms, so the training for these products wouldn’t be useful to those advisors.

“Given the complexity of alternative funds, adding this content to the base licensing exam could significantly divert focus and examination weighting away from the more relevant areas of proficiency,” the CSI’s comment states. Instead, it continues, training on alternative funds should be an option for fund dealer reps as their client base evolves.

FAIR Canada’s comment argues that the need for specific training on alternative funds shouldn’t be limited to just MFDA reps, adding that reps with Investment Industry Regulatory Organization of Canada-licensed firms will need additional education too, as will dealers’ supervisory personnel.

But, more fundamentally, FAIR Canada’s comment argues that no part of the CSA’s proposal should be allowed to proceed until conduct standards in the industry are raised: “The present securities regulatory framework does not provide adequate investor protection for mainstream products such as mutual funds, let alone complex products such as alternative funds.”

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