Staff of the OSC recently released a report summarizing their findings from their targeted continuous disclosure review of a number of mutual funds. Staff examined funds investing in high-yield debt funds, emerging market funds, and small cap equity funds, since funds of those types may be more prone to liquidity concerns. The review focused on the policies and procedures of the funds – specifically, whether those policies identified potential illiquid assets and addressed the ability to manage higher levels of redemptions under different stress conditions, and whether the funds’ valuation processes had taken liquidity into consideration. The theme of the report suggests that funds require robust policies to assess liquidity both at the time of investment and on an ongoing basis.
Staff emphasized that investment fund managers cannot take the view that equity investments are liquid solely because they are listed on an exchange, without any consideration of market conditions and activity (which would include volume metrics, bid/ask spreads and the outstanding issue size). The review found some examples where certain securities did not have the market activity needed to permit a sale if needed within the short period of time permitted for redemptions under NI 81-102. The report also described some good market practices, where managers have established committees to determine whether an asset is illiquid. The use of these committees, some of which included technical experts, are seen to add objectivity and expertise into the liquidity assessment process.
While most managers engaged in stress testing to assess their funds’ ability to meet unexpected large redemptions, not all managers did. Of the managers that used scenario analysis, the analysis tended to incorporate only historical redemption rates and did not use higher levels than the funds’ past experience, which staff encouraged. Staff also suggested that managers consider stress testing for portfolio performance, and that funds should provide additional disclosure of their risk management policies and investment restrictions used to mitigate liquidity risk.
With respect to valuation practices, staff indicated that closing market values were generally used for equity investments without further considering market activities and conditions. Managers did generally use ancillary information for fixed income investments, such as over-the-counter (OTC) broker quotes and data freshness reports. Interestingly, staff referred to IFRS 13 Fair Value Measurements, and indicated that a fund’s determination of whether or not a security is quoted in an active market under IFRS 13 must be taken into consideration in determining whether or not the investment is illiquid under NI 81-102. If the security is not quoted in an active market, additional disclosure is required in the funds’ financial statements with respect to fair value. Of interest to fund managers was the closing of the report, where it was noted that staff expects managers to obtain standing instructions from the funds’ Independent Review Committee concerning their valuation policies and procedures.