WHAT ARE THE BENEFITS OF SIDE-POCKETING IN MUTUAL FUNDS

Last Updated: 7 Mar 2024

In the last few years, you must have heard of the concept of side-pocketing of funds quite often. This is more so with respect to debt funds. If you look at the latest AMFI monthly sheet of flows into equity and debt funds, a total sum of Rs.638 crore of funds are side pocketed across some 16 different schemes. Out of the Rs.638 crore that has been side pocketed, nearly Rs.603 crore pertain to debt funds and the balance to hybrid funds. Let us first understand the concept of side pocketing.

WHAT EXACTLY IS SIDE POCKETING?

You normally don’t keep all your money in your front pocket or in the back pocket. As an emergency measure, you always set aside some money in the side pocket. That is how the word side pocketing comes. Typically, a Side Pocket refers to a segregated portfolio in a mutual fund scheme. Within the overall debt portfolio of a fund, certain securities or group of securities are segregated and set aside in a side pocket; distinct from main portfolio.

Normally, this side pocketed portfolio refers to that part of the portfolio that has had a negative credit event. For instance, if company X defaults on its debt, then the security holdings of the mutual funds pertaining to that particular security are side-pocketed. Side pocketing is a recent phenomenon in India and was only permitted by SEBI in the month of December 2018.

SEBI has set clear rules and regulation pertaining to side pocketing. Mutual funds are allowed to create Segregated Portfolios or side pockets of selected debt and money market instruments, which carry a high credit risk. This will ensure that the toxic nature of these securities does not impact the quality of the entire portfolio. The ideas of side pocketing is to protect the interest of the investors in debt funds.

HOW SIDE POCKETING WORKS IN PRACTICE?

This normally happens when there is a downgrade of certain debt securities by the rating agencies. The first impact is on the price of the bond which crashes as yields shoot up. That means, funds holding these bonds will have to make provisions accordingly. This can create huge losses and impact the NAV of even the small investors. That is because, as per SEBI guidelines, when the credit rating is dropped below investment grade, mutual funds must appropriately adjust the valuation of debt securities in the mutual fund scheme.

In many cases, the problem may only be temporary. Hence such markdowns may reverse in the future, when the actual recovery happens. This opens the road to short term traders to buy the fund at lower NAVs and make a quick profit when the NAVs bounce back. However, this is unfair to the long term investors in the debt fund and the side pocketing is done to protect the interests of these small investors. The idea of side pocketing is to favour the long term loyal investors over the short term traders who are looking at a punt.

ILLUSTRATING THE OPERATION OF SIDE POCKETING

Let us look at a live example of how side pocketing would work in practice. Consider a mutual fund scheme that has a 10% portfolio exposure to the bonds of Company X. Now, let us say this company defaults on the payment of interest due to a cash crunch. As such, the bonds would be downgraded by the rating agencies and the mutual funds now have to mark down these bonds based on the haircut matrix proposed by AMFI depending on rating and the industry in which the issuer company operates.

To the extent of the markdown, the NAV of the debt fund will fall vertically. However, the problems for the company may be just temporary and it may get back to normal functioning after 6 months. Such recovery will push the NAV higher immediately, which will benefit only the investors as on that date, even if they may or may not have suffered the markdown in the valuation of such bonds. In short, many smart traders make hay while the sun shines and the long term loyal investors pay the cost for the same.

That is when side pocketing enters the picture. Under the rules of side pocketing, the toxic portfolio pertaining to the stressed issuer are segregated from the main scheme portfolio. The segregated portfolio becomes like a closed ended fund and does not allow any entry or exit from the fund. As a result, if and when the recovery happens, the total recovery from the segregated portfolio belongs to the loyal and long term unitholders. The sooner the toxic portfolio is side pocketed and kept separate from the main portfolio, greater are the chances that the recovery will be enjoyed by the original investors.

HOW EXACTLY DO MUTUAL FUNDS CREATE SEGREGATED PORTFOLIOS?

The first thing is the decision on the creation of side pocket. Normally, the decision is taken on the day of the credit even itself. Once the mutual fund decides on creation of segregated portfolio (aide pocket), trustee approval is required within one working day. Once the approval comes in, an equal number of the units of the segregated portfolio are allotted to all the existing investors as on the day of credit event. In addition, NAV of the segregated portfolio and main portfolio are disclosed on a daily basis.

For the segregated portfolio, the fund has to declare NAV of the portfolio with the disclosure on the components of the side pocketed portfolio. This fact has to be also disclosed by the fund in all its routine disclosures. Once the segregated portfolio is created, no redemption is allowed in the segregated portfolio for the investors. However, such side pockets have to be mandatorily listed on the stock exchange within 10 working days of the side pocket. While listing does not make it liquid, it offers a back-up exit route.

IS SIDE POCKETING MANDATORY FOR ALL STRESSED PORTFOLIO HOLDINGS?

Side pocketing is an option given by SEBI to mutual funds. The decision must ultimately rest with the AMC about whether to take up the side pocket or not. It is an option which is only triggered in the case of a negative credit event. Normally, mutual funds tend to ignore small event risks. However, if the credit risk and its impact is substantial, then the side pocketing is a good idea to protect the interests of the investors at large. The mutual fund cannot create any fresh units of the segregated portfolio, and all the purchase transactions in the mutual fund scheme will be based on the non-segregated portfolio only.

IS THE TAX TREATMENT OF SEGREGATED PORTFOLIO DIFFERENT?

What would be the date of purchase of the segregated portfolio holdings. Would it be the date of original purchase or the date on which the portfolio is segregated. In case, you invested in the debt fund earlier and units of the segregated portfolio were received at a later stage, period of holding for the units of the segregated portfolio will be reckoned from the date of the original investment.

This has been adequately clarified in the Union Budget 2020. The original cost of investment will be allocated between the main portfolio and the segregated portfolio in the same ratio as the NAV of the main portfolio and segregated portfolio immediately before the credit event. All other details pertain to tax of segregated portfolio is the same as regular mutual funds.