What is side pocketing in mutual funds?
The side pocketing is a framework that allows mutual funds (MFs) to segregate the bad assets in a separate portfolio within their debt schemes. In December 2018, Securities and Exchange Board of India (SEBI) introduced the side pocketing framework on the back of IL&FS fallout, which had failed in meeting its commitments to creditors and lenders, putting a lot of pressure on the net asset value of most debt funds that owned IL&FS group papers in their portfolio. Under this framework, SEBI allowed MFs to separate the stressed assets from good quality liquid assets in a bid to protect retail investors from the risky investments.
Though this framework was introduced by SEBI recently, the concept is not a new one in the Indian context. In 2015, JP Morgan was facing a potential default by one of its portfolio companies, Amtek Auto Ltd. Amtek Auto was part of two of JP Morgan's funds. Initially, JP Morgan restricted redemptions in the funds. They separated their investments in the funds into 2 parts, one set of units contained its holdings in Amtek Auto (side-pocket), while the other set of units contained all its holdings apart from Amtek Auto, including cash reserves. Thereafter, they lifted the restrictions on redemptions. Since then, SEBI has made redemption rules a lot more stringent. In 2016, SEBI issued a regulation prohibiting restriction of redemptions, except under certain extreme situations.
How does side pocketing work?
If a debt instrument is downgraded to default rating by credit rating agencies, then the mutual funds have the option to create a side pocket so that good assets can be ring-fenced. All existing investors in the scheme are allotted equal number of units in the segregated portfolio as held in the main portfolio and no redemption or subscription is allowed in the segregated portfolio. For example, if a fund’s NAV is Rs100 and one bond which contributes Rs10 to overall NAV has some credit issues, the fund house segregates the portion of that stressed assets valuing 10 from its total value. Now, Rs90 will be treated as usual but the rest Rs10 will be taken aside. Thereafter, the units (in the segregated portfolio) have to be listed on a stock exchange within 10 days to facilitate exit of the unit holders. Essentially, this helps price discovery of the bad assets, with investors having the freedom of either selling it at prevailing price or holding it if they expect the value to recover in future. Of course, the write off will still be taken but the side pocket ensures that short term traders do not make profits in distress at the expense of genuine investors who exited the fund. Funds normally write off 75% in case of distressed assets and any recovery from these toxic assets are directly credited into the side pocket account and paid back to the investor.
Few important points about mutual fund side pocketing at a glance
- SEBI has made mutual fund side pocketing compulsory to avert liquidity risks by separating money market and debt instruments from illiquid investments.
- This segregation, which is done when there is a rating downgrade of a mutual fund scheme, allocates the units to the existing investors on a pro rata basis.
- The NAV of the mutual fund then reflects the value of the liquid holdings, and assigns a separate NAV to the side pocket mutual funds.
- Only the investors who were invested in the mutual fund at the time of the credit downgrade, benefit from the future recovery and growth of the fund.
How does side pocketing impact investors?
- Side pocketing offer investors the benefit of selling the liquid investment and staying invested in the risky funds till they generate healthy returns. If these risky bets generate returns, they are passed on to the investors. Thus, side pocketing may lead to liquidity of investments that have faced a credit downgrade.
- Side-pocketing is easing the hassle that once accompanied risky investments. Previously, investors would exit funds which were downgraded in order to achieve returns at a higher NAV. Side pocketing is changing this scenario drastically, enabling investors to remain invested in the illiquid assets. After these assets generate returns, the original unitholders will be reimbursed.
- Investments in the bad asset will be close for subscription, while investors will be allowed to subscribe/redeem their investments in the healthy assets.
- Side pocketing protects investors who remain invested. They don’t have to worry about the sale of quality assets, which would result in a drop in the NAV. Investors who exit will get an accurate NAV that reflects the value of the liquid assets.
How does it impact AMCs and fund managers?
- Without side pocketing, the fund manager would have to sell the quality assets to pay the investors who redeem their investments in panic. If a stressed asset is side-pocketed, the perception of the bad assets gets removed from the equation, which limits the fund redemption by existing investors.
- When a company defaults in its payments, there are a number of redemption requests. As a result, toxic assets form a larger part of the scheme. Side pocketing helps fund houses manage redemption pressures better, and protect all other investment holdings from being impacted. Creating a side pocket insulates the rest of the debt funds’ portfolio from such rotten apples.
- Ring-fencing risky mutual funds help fund managers tackle redemption pressures better, while ensuring that the other liquid and cash holdings are not adversely affected. This gives them enough opportunity to focus on recovering investments made in illiquid assets. And that too, without unnecessarily adding to the pressure of the other investors.
- One of the challenging areas of side-pocketing is to evaluate the stressed asset value in the current NAV as the value of the illiquid asset is a theoretical matter. It is possible that one method works in one situation but not in others. It would be hard to come up with the exact NAV of the stressed as well as the liquid assets. The hardened work would certainly increase the complexities for the fund houses.
- SEBI has also suggested an indicative list of safeguards that may be implemented by the AMC so that the provision of side-pocketing is not misused.
Side pocket as a strategy is globally considered one of the best ways to protect the interests of the small investors in a mutual fund. However, this strategy is yet to take off resoundingly in the Indian mutual fund industry. Most MFs prefer to either freeze fresh inflows or impose heavy exit loads on the fund to impose a cost on fund traders. All things considered, adopting this concept would eventually result in the safety and smooth function of the fund where the investors would be saved from the undue panic and fund house will be prevented from getting undue advantage.