Proposal suggests improvement on CSA risk methodology, adds considerations for private credit funds
Earlier this year, Canadian securities regulators widened the path for alternative mutual funds to be distributed in the retail space through blanket relief that allowed more proficiency options for mutual fund dealing reps. While that was a significant step forward for the space, the Alternative Investment Management Association (AIMA) believes there’s even more room to help the industry flourish.
In partnership with the Chartered Alternative Investment Analyst Association (CAIA Association), AIMA has released a set of proposed risk rating guidelines that would apply to hedge funds, alternative mutual funds and ETFs, and private credit in Canada.
The guidelines – which update proposals they published in 2019 by including private credit funds – are aimed at addressing limitations to the Canadian Securities Administrators’ (CSA) risk rating methodology that’s based on standard deviation.
“This methodology … is adequate for most traditional long-only strategies but may also understate the risk in alternative investment strategies, which tend to have ‘fat tail’ risk events,” AIMA and CAIA Association explained. “However, IIROC dealers often place too high a risk rating on alternative funds, thereby significantly limiting their potential inclusion in retail client portfolios and reducing investors’ access to these products than can provide diversification, volatility protection and non-correlated returns.”
To better reflect historical risk-adjusted data for alternative funds, the proposed guidelines for hedge funds and alternative mutual funds – including market neutral equity, equity long short, and relative value arbitrage strategies – rely on the median trailing standard deviation of funds within indices defined by the Center for International Securities and Derivatives Markets (CISDM).
With respect to private credit funds, the proposed guidelines said the key risk considerations are the seniority vs. subordination of a particular loan, along with the degree to which it has covenants that protect the lender or investor by requiring disclosures and placing limitations on borrowers’ financial activities. Based on that, it draws distinctions of riskiness between funds that are underpinned by senior and secured loans, unitranche loans, and leveraged loans, among other types of private debt.
“Alternative investments are diverse and need to be evaluated properly and individually based on manager and strategy,” AIMA and CAIA Association said. “They play a key role in a balanced portfolio by offering diversification, risk reduction and noncorrelated returns to the investor.”