NIN 2000/24 - Publication for Comment of Proposed Amendments to National Instruments 81-101 Mutual Fund Prospectus Disclosure and 81-102 Mutual Funds - Relating to Index Mutual Funds and Other Matters [NIN - Rescinded]

The Commission, together with other members of the Canadian Securities Administrators (“CSA”), is publishing for comment proposed amendments to National Instrument 81-102 Mutual Funds (“NI 81-102”), Companion Policy 81-102CP (“81-102CP”), National Instrument 81-101 Mutual Fund Prospectus Disclosure (“NI 81-101”), Companion Policy 81-101CP (“81-101CP”), Form 81-101F1 Contents of Simplified Prospectus (“Form F1”) and Form 81-101F2 Contents of Annual Information Form (“Form F2”) (all collectively referred to also as the “Proposed Amendments”).

The Proposed Amendments are initiatives of the CSA. The proposed amendments to NI 81-101, NI 81-102, Form F1 and Form F2 are expected to be adopted as a rule, regulation or other appropriate instrument in each of the jurisdictions represented by the CSA. 81-101CP and 81-102CP are expected to be implemented as policies in each of the jurisdictions represented by the CSA.

Summary of the Proposed Amendments

The Proposed Amendments would:

• allow an index mutual fund to invest a percentage of its net assets in any one issuer in excess of the 10 percent concentration restriction that is prescribed by section 2.1(1) of NI 81-102; 
  
• require an index mutual fund to include specific disclosure in its simplified prospectus about its fundamental investment objective, and the risks inherent in the fund investing in securities according to an index that is itself not widely diversified; 
  
•  require a mutual fund to disclose its management expense ratio in media other than the simplified prospectus, annual information form and audited financial statements, based on a “rolling” 12 month period; and
  
• require a mutual fund offering multiple classes of securities to provide cover page disclosure in its simplified prospectus of the classes offered and to provide performance and financial highlight disclosure in the simplified prospectus for different classes.

The Proposed Amendments also make a number of other changes that address some issues that have been brought to the attention of the CSA following the coming into force of NI 81-101, NI 81-102, Form F1 and Form F2 on February 1, 2000.

Background to Amendments Relating to Index Mutual Funds

Since the summer of 1999, the CSA have been urged to permit index mutual funds to invest their net assets in the securities of issuers that make up their target index without being limited by the 10 percent concentration restriction currently prescribed by section 2.1 of NI 81-102. These concerns resulted from the recent and arguably novel market conditions that have caused the weighting of certain issuers in certain indices to rise substantially above 10 percent. The concentration restriction in section 2.1 of NI 81-102 prevents index mutual funds from replicating the performance of their target indices. Generally, index mutual funds meet their stated investment objective by purchasing or gaining exposure to the securities of the issuers in their target index in the same proportion as such securities are reflected in such index.

As a result of applications for discretionary relief made by certain index mutual funds, the CSA granted those funds exemptions from the concentration restriction applicable to mutual funds (at that time, section 2.01 (a) of National Policy Statement No. 39), subject to a restriction that limited such funds to a 15 percent concentration restriction and then later to a 25 percent concentration restriction.

In the course of deciding to propose an elimination of the concentration restriction for index mutual funds, the CSA considered the equivalent of the concentration restriction rule in other regulatory regimes such as the United States, Hong Kong, and Europe.¹

¹ For example, the Hong Kong Securities and Futures Commission (“SFC”) imposes a 10 percent diversification rule similar to NI 81-102. To date the SFC has granted discretionary exemptions from that rule but only to index mutual funds. The SFC has not imposed any upper limit for index tracking funds in their exemptions, provided that the weightings of the individual stocks within the fund track those of the fund’s target index. The Securities and Exchange Commission in the United States allows a “diversified” mutual fund to invest up to 25 percent of its assets in a single issuer; however the SEC also requires that the remaining 75 percent of the fund’s assets be invested such that no one holding constitutes more than 5 percent of the fund’s assets. Mutual funds must ensure, at least quarterly, that they are in compliance with these restrictions. Mutual funds established under the UCITS Directives of the European Commission must abide by restrictions less flexible than NI 81-102 (a 5 percent “ongoing”, rather than “purchase”, concentration restriction). These restrictions are proposed to be lessened for index mutual funds; however index mutual funds will still be subject to a restriction of 35 percent of all assets invested in any one issuer should the proposals be adopted by the member countries.

In all cases, although the concentration restriction has been or is proposed to be lessened for index mutual funds in those jurisdictions, it has not been eliminated in its entirety. The CSA considered alternatives to the elimination of the concentration restriction for index mutual funds, as discussed later in this notice under “Alternatives Considered”.

The Investment Funds Institute of Canada urged the CSA to do away with the concentration restriction for all mutual funds, and not just index mutual funds. The CSA are proposing to eliminate the concentration restriction only for index mutual funds for the following reasons:

• The CSA are of the view that tracking an appropriate market index is an acceptable proxy for the concentration restriction. There is no other widely accepted and disclosed proxy for actively managed funds.
  
• Managers of actively managed funds have alternative investment strategies available to them and are responsible for following these investment strategies in seeking to achieve a fund’s objective. For example, although the 10 percent restriction limits how much an actively managed mutual fund can overweight a given issuer, it does not limit the extent to which such a fund can overweight a market sector or a group of issuers whose stock prices are correlated.
  
• Only in the context of index mutual funds can it be argued that the 10 percent restriction prevents a manager from pursuing the fundamental investment objective of the mutual fund, i.e., tracking the performance of a specified index.

The proposed amendments to NI 81-102 define “index mutual fund” as a mutual fund that has adopted fundamental investment objectives that require it to:

• hold securities that are included in a permitted index or indices in substantially the same proportion as those securities are reflected in that permitted index or indices; and;
  
• invest in a manner that causes the mutual fund to replicate the performance of that permitted index or indices.

The proposed amendments to NI 81-102 exempt index mutual funds from the concentration restriction contained in section 2.1 of NI 81-102. The CSA wish to allow an index mutual fund to pursue its fundamental investment objective of tracking the composition (and therefore the performance) of a specified index or indices, provided adequate disclosure is given to investors of this objective. An index mutual fund will be permitted to rely on the exception to the 10 percent concentration restriction if it:

• provides specific disclosure in its simplified prospectus as provided in the proposed amendments to Form F1;
  
• provides 60 days advance notice to securityholders before first relying on the exception;
  
• includes the word “index” in the name of the mutual fund.

The proposed amendments to Form F1 are designed to give investors sufficient notice and information about the fundamental investment objectives of index mutual funds and the risks inherent with such objectives where the concentration restrictions applicable to all mutual funds are not followed.

In addition, the CSA propose a related amendment to Form FI that will require all mutual funds, and not just index mutual funds, to disclose the risks of a high concentration of portfolio assets in any one issuer. The proposed disclosure requirement will require a mutual fund to disclose additional risks where, at any time during the previous 12 month period before the date of its simplified prospectus, the mutual fund held more than 10 percent of its net assets in securities of any one issuer.

Since investors in existing index mutual funds would have acquired their index mutual funds at a time when the fund could not go beyond the 10 percent concentration restriction, the CSA believe it necessary for index mutual funds to inform investors of their intentions to rely on the exception provided in the proposed amendments. Accordingly, all index mutual funds that propose to rely on the exception must give investors 60 days advance notice and give them the information required by section 2.1 so that the investors can make an informed decision on whether they wish to remain invested in these index mutual funds. The CSA propose this notice requirement for all index mutual funds, including those index mutual funds that have received discretionary relief under National Policy Statement No. 39 or NI 81-102 to go beyond the 10 percent restriction to up to 25 percent in any one issuer.

Section Numbering of Proposed Amendments

The CSA have already proposed amendments to NI 81-102, 81-102CP and Forms FI and F2 to, among other things, permit mutual funds to enter into securities lending, repurchase and reverse repurchase agreements. Those proposed amendments were published for comment in January 2000²

² NIN #2000/4

and the comment period expired on April 30, 2000. The CSA expect that those amendments will be in force before the amendments contemplated by the current Proposed Amendments. The numbering of section references in the Proposed Amendments and in this Notice, assumes that the “securities lending/repo amendments” are already in force and takes into account numbering changes made by those earlier proposed amendments.

Alternatives Considered

The CSA considered maintaining a concentration restriction for index mutual funds, albeit beyond the current 10 percent concentration limit in section 2.1 of NI 81-102. The CSA determined to publish for comment the proposed amendments that do not have any concentration restriction for mutual funds since they decided that index mutual funds should be permitted to follow their fundamental investment objectives (that is, tracking the performance of an index) without restriction. The Proposed Amendments represent the CSA’s views on an appropriate regulatory response that balances the needs and particular characteristics of index mutual funds with the investor protection concerns that arise when mutual funds are not fully diversified.

The CSA are aware that there are some indices in which one issuer makes up a very significant percentage of the index. The CSA believe that the combination of the proposed amendments relating to the concentration restriction for index mutual funds and the increased disclosure requirements will provide sufficient protection to investors from the risks inherent in investing in index mutual funds tracking such indices.

Comments on any alternatives to the CSA’s proposed response to the issues surrounding index mutual funds can be provided during the comment period.

Anticipated Costs and Benefits

The Proposed Amendments to enable index mutual funds to follow their stated fundamental investment objective without restriction may bring improved performance for index mutual funds, which will benefit investors. Conversely, index mutual funds that are no longer subject to any concentration restriction may suffer greater losses than when their exposure to any one issuer was limited to 10 percent of their net assets. While the removal of the concentration restriction for index mutual funds does lead to increased risk, such risk and related potential consequences on the mutual fund will be disclosed to investors.

The Proposed Amendments relating to index mutual funds are expected to reduce the costs to those funds in ensuring compliance with the concentration restrictions by allowing them to focus on tracking their target permitted index. These funds will be required to amend their simplified prospectus to include the required disclosure and send a 60-day advance notice to security holders before they are entitled to rely on the relief. Although there will be costs associated with this, the CSA believe that they are more than offset by the need to give investors advance notice of the changes to their index mutual fund.

The requirement to calculate MER for a “rolling” 12 month period in addition to the current requirement that the calculation be based on a completed financial year may require mutual funds to incur additional costs. However, investors are expected to benefit from more current and accurate figures.

The requirement to make front page disclosure of classes or series of units of mutual funds, together with the additional disclosure clarifications relating to these mutual funds, are not expected to result in any additional material cost. Investors will benefit from the clearer disclosure

Comments

Interested parties are invited to make written submissions with respect to the Proposed Amendments. Submissions received by September 14, 2000 will be considered.

Submissions should be sent to all of the Canadian securities regulatory authorities listed below in care of the Ontario Securities Commission, in duplicate, as indicated below:

British Columbia Securities Commission
Alberta Securities Commission
Saskatchewan Securities Commission
The Manitoba Securities Commission
Ontario Securities Commission
Office of the Administrator, New Brunswick
Registrar of Securities, Prince Edward Island
Nova Scotia Securities Commission
Securities Commission of Newfoundland
Registrar of Securities, Northwest Territories
Registrar of Securities, Yukon
Registrar of Securities, Nunavut

c/o John Stevenson, Secretary
Ontario Securities Commission
20 Queen Street West
Suite 800, Box 55
Toronto, Ontario M5H 3S8
jstevenson@osc.gov.on.ca

Submissions should also be addressed to the Commission des valeurs mobilières du Québec as follows:

Claude St. Pierre, Secretary
Commission des valeurs mobilières du Québec
800 Victoria Square
Stock Exchange Tower
P.O. Box 246, 22nd Floor
Montréal, Québec H4Z 1G3
claude.stpierre@cvmq.com

A diskette containing the submissions (in DOS or Windows format, preferably WordPerfect) should also be submitted. As securities legislation in certain provinces requires that a summary of written comments received during the comment period be published, confidentiality of submissions cannot be maintained.

Comments may also be sent via e-mail to the above noted e-mail addresses of the respective Secretaries of the Ontario Commission and of the Commission des valeurs mobilières du Québec, and also to any of the individuals noted below at their respective e-mail addresses.

Questions may be referred to any of:

Noreen Bent
Senior Legal Counsel
British Columbia Securities Commission
(604) 899-6741
or (800) 373-6393 (in B.C.)
nbent@bcsc.bc.ca

Wayne Alford
Legal Counsel
Alberta Securities Commission
(403) 297-2092
wayne.alford@seccom.ab.ca

Dean Murrison
Deputy Director, Legal
Saskatchewan Securities Commission
(306) 787-5879
dean.murrison.ssc@govmail.gov.sk.ca

Bob Bouchard
Director, Capital Markets and Chief Administrative Officer
The Manitoba Securities Commission
(204) 945-2555
bbouchard@cca.gov.mb.ca

Rebecca Cowdery
Manager, Investment Funds
Capital Markets
Ontario Securities Commission
(416) 593-8129
rcowdery@osc.gov.on.ca

Anne Ramsay
Senior Accountant, Investment Funds
Capital Markets
Ontario Securities Commission
(416) 593-8243
aramsay@osc.gov.on.ca

Paul Dempsey
Senior Legal Counsel, Investment Funds
Capital Markets
Ontario Securities Commission
(416) 593-8091
pdempsey@osc.gov.on.ca

Chantal Mainville
Legal Counsel, Investment Funds
Capital Markets
Ontario Securities Commission
(416) 593-8168
cmainville@osc.gov.on.ca

Pierre Martin
Legal Counsel, Service de la réglementation
Commission des valeurs mobilières du Québec
(514) 940-2199, ext. 4557
pierre.martin@cvmq.com

Proposed Amendments

The text of the Proposed Amendments follow, together with footnotes that are not part of the Proposed Amendments, but have been included to provide background and explanation.


DATED at Vancouver, British Columbia, on June 15, 2000.


Joyce C. Maykut, Q.C.
Vice Chair

Ref: NIN#2000/4
NI 81-101
NI 81-102
Form 81-101F1
Form 81-101F2
Companion Policy 81-101CP
Companion Policy 81-102CP

This NIN refers to other documents. These documents can be found at the B.C. Securities Commission public website at www.bcsc.bc.ca in the Commission Documents database.