CSA – Comment Letter – 81-102 Alternative Fund Amendments

December 22, 2016

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CSA – Comment Letter – 81-102 Alternative Fund Amendments

Letter Summary:

We wish to stress the importance of the CSA implementing a regulatory best interest standard on all persons providing investment advice, which would help ensure that any recommendation under the proposed regime to buy an alternative mutual fund is in fact in a client’s best interest. In the absence of such a standard, we have concerns about the appropriateness of some of the contemplated permitted strategies for the retail market under the proposal as more specifically addressed below.

Overview of the Council’s Comments:

While standard deviation is an informative measure, it is not a complete measure of risk in any investment situation, and as has been highlighted above, it can mask risks that arise as a result of the complexity of an investment product. As an illustrative example, a short-term fixed income mutual fund could have very low historical volatility over the measurement period in question, ut be quite risky as a result of the complexity of the fund’s underlying investments, some of which could have very asymmetric risk profiles in the event of a credit event, liquidity issues, or an interest rate shock. The risk rating of the fund, based on standard deviation, would 00155342-6 8 have given the investor no insight into the asymmetric risk profile and complexity of the fund’s investments. The Journal of Finance published a paper [A Risk and Complexity Rating Framework for Investment Products] (Koh et al.) discussing a complexity rating framework, which would help inform and augment traditional risk ratings. The paper describes other vectors that could be considered for risk measurement and required mutual fund disclosures in future projects. Another consideration is that standard deviation is an unreliable risk metric to use with respect to alternative mutual funds because these funds may employ illiquid or infrequently priced securities such as physical commodities, OTC derivatives, or mortgage investments. Infrequent pricing of these illiquid instruments can conceal the true risk exposure by lowering the standard deviation and risk rating for the fund, which in turn exposes the retail investor to unintended risks and potential negative consequences.