Mutual Fund Compensation and Reinvestment Practices Face OSC Scrutiny

The OSC recently published its 2014 Summary Report for Investment Fund and Structured Product Issuers which includes, among other topics, a summary of key OSC policy initiatives affecting investment fund issuers and highlights of 2014 continuous disclosure and compliance reviews of investment funds The report also sets out OSC Staff observations on key emerging issues and trends for mutual funds.

OSC criticizes reinvestment of distributions by “default”

Some mutual funds offer a choice between making distributions to investors in cash, or in the form of reinvested units. OSC Staff is concerned about mutual funds that set the payment of distributions in the form of reinvested units as the default option and only pay distributions in cash if investors specifically request it. Staff wants mutual fund investors to make the decision.

Of particular interest to the OSC are situations where a default option to make distributions in the form of reinvested units would result in additional fees for the investor. For example, units purchased under a deferred sales charge option would not be subject to additional redemption fees if distributions are made in cash, but would attract additional redemption fees if the distributions were made in the form of reinvested units.

The OSC is undertaking a review of both existing and new mutual funds to ensure that the use of default features does not interfere with the quality of the client/advisor relationship:

  • For existing funds with a deferred sales charge option and a default distribution reinvestment option, Staff will analyze the effect of default options on redemption fees and intervene, presumably during the next annual prospectus renewal process or by way of targeted review, by asking fund managers to advise Staff what would be a reasonable transition period needed to remove any default options, as well as steps involved in doing so.
  • For new funds being launched, Staff will closely examine and question structures that may give rise to potential conflicts of interest or investor protection concerns, such as funds with a default feature that causes distributions to be automatically reinvested in additional units of the fund without investor instructions.

Fee-based series with dual dealer compensation

OSC Staff is reiterating its position, previously announced in November 2014, that a mutual fund series intended for fee-based accounts should not also have a trailing commission embedded in the ongoing cost of the fund series. In the OSC’s view, this compensation structure is inconsistent with fee-based mutual fund series because of the extra trailing charge on top of the fee. As we discussed in another post on this topic, the OSC is taking steps to eliminate trailing commissions for fee-based mutual fund series when they file their next annual renewal prospectuses.

Changes to short-term trading fees

Short-term trading in a mutual fund’s securities can have an adverse effect on the mutual fund. Such trading can increase brokerage and other administrative costs of the fund and interfere with the long-term investment decisions of the fund manager. Mutual fund managers have a fiduciary duty to maintain effective policies and procedures to deter shot-term trading activities (such as market timing and excessive trading), including by adopting certain restrictions and fees. The fee structure normally operates so that, if an investor redeems or switches units of the mutual fund within a certain number of days of purchase (typically between 30 to 90 days), the investor may be subject to a short-term trading fee (typically between 1% and 2% of the amount redeemed or switched).

OSC Staff became aware of some fund managers who had changed their short-term trading fee practices and policies to reduce from 30 days to only 7 days the period of time during which redemptions trigger short-term trading fees. If a fund manager changes their short-term trading fee practices, Staff will make enquiries to understand the reason behind the change and to ascertain:

  • what other policies and procedures the manager has in place to monitor, detect and deter short-term trading, in particular,
  • whether the fund manager varied its short-term trading policies and procedures in relation to the two different types of short-term trading activities, namely market timing and excessive trading; and
  • for trade monitoring, regardless of the reduction of the redemption fee period from 30 days to 7 days, whether the fund manager will continue with the previously used time frame to monitor these trading activities and to apply the appropriate action;
  • how effective the manager’s policies and procedures have been to date in monitoring, deterring and detecting short-term trading activities; and
  • whether the reduction of the redemption free period was reviewed by the independent review committee and any other governance bodies of the funds, and the frequency with which the fund manager will evaluate the effectiveness of its short-term trading policies going forward.

Staff previously expressed the view that mutual fund short-term trading policies that suspend redemptions by “blocking” an investor account from further transactions for a certain period of time are not an appropriate mechanism to address the deleterious effects of short-term trading.

Official OSC publications such as the Summary Report and the Investment Funds Practitioner are becoming increasingly important channels for OSC Staff to set out legal interpretations and observations which might not otherwise be specifically articulated in official companion policies or investment fund rules. We continue to monitor these publications.

Liquidity levels of individual fund holdings come under scrutiny

In 2014, the OSC conducted a review of fixed income funds to assess the adequacy of their processes around portfolio risk management and disclosure relating to risk and market events.

OSC Staff has since expanded these reviews beyond the fixed income segment to focus on other asset classes that may also be susceptible to liquidity issues. In particular, the OSC is targeting managers of funds with exposure to high yield fixed income, small cap equity funds, and emerging market issuers by:

  • seeking clarification regarding policies and procedures around evaluation of liquidity levels of individual fund holdings;
  • asking how fund holdings fit within the restrictions concerning illiquid assets, as set out in Part 2.4 of NI 81-102;
  • asking about any stress testing and scenario analysis the fund managers may have conducted for their fund portfolios;
  • enquiring about the valuation of illiquid assets, the valuation policies and procedures more generally, and whether there is any oversight by the independent review committee; and
  • reviewing risk disclosure in offering and continuous disclosure documents.

OSC Staff expects to publish a notice in spring 2015 that will outline the findings of these reviews and will formulate best practices for liquidity assessment protocol, portfolio risk management, and disclosure.

2014 Summary Report for Investment Fund and Structured Product Issuers cash distribution continuous disclosure continuous disclosure review default deferred sales charge distribution fee-based accounts IRC liquidity mutual fund mutual fund dealer compensation OSC redemption fees reinvested units short term trading fee trailer fees trailing commissions



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