Post the IL&FS catastrophe, the SEBI has introduced a new reform that allows fund houses to segregate good funds and bad funds. In light of recent events, the companies are also following a stringent practice and informing the investors regarding their act of segregation.
What is the side pocketing of mutual funds?
Side pocketing refers to maintaining a separate account for bad assets within their debt fund scheme portfolio. This is primarily done so that the fund houses who are involved with troublesome funds can be kept at a bay form the potential return of investors. This framework was introduced in the month of December by the Securities and Exchange Board of India in the interest of the investor’s potential return.
Some Mutual Fund house like HDFC Mutual Fund, SBI Mutual Fund have started incorporating side pocketing in their debt schemes. This allows bad securities to be separated from the good one.
How does side pocketing work?
The SEBI which is also the regulator of the market has laid down several guidelines with respect to the portfolio creation for a particular fund type that might be in some trouble. To fall under the side pocket category, the fund has to be either below investment grade or a credit event that might have occurred at the issuer’s level leading to a subsequent degrade in the positioning of the money market instrument or debt instrument.
Simply put, side pocketing is essentially safeguarding the good assets from the bad assets that have fallen to a below investment grade level so that the overall profit of the investor is not affected.
Did you Know: UTI Mutual Fund and Reliance Mutual Fund had side pocketed their stressed investment in troubled Altico Capital India.
How do investors benefit from a side pocket?
It is an excellent tool that safeguards the investors form the potential harm that a bad asset can cause. Side pocketing basically separates good assets and bad assets wherein all the investors under the mutual fund scheme are allotted equal parts of the side pocketed portfolio just like they do in the main portfolio. The investors can neither redeem nor subscribe to the side pocketed portfolio.
Now, once the segregated portfolio is made, the units under this portfolio need to be listed on the stock exchange for transparent trading. This listing needs to be done within a period of 10 days such that the investors can be freed from the bad assets as soon as possible. The underlying investors are free to sell off the segregated units at the running price or can hold the units if they believe the fund will recover.
Can side pocketing be misused?
As soon as SEBI introduced the concept of side pocket, the market watchers were concerned about the potential ways in which the reform can be misused. The biggest concern was regarding the fund houses and mutual fund companies misusing this reform to hide theory bad investment decisions in a side pocket. Later, the SEBI laid down a condition stating that the fund managers who would have side pockets under their management of a fund will be rated lowly in their performance hence decreasing their appraisal. Thus, the manager who will have more side pockets under them will earn lower incentives. The regulator has also advised the board members and directors to be very careful and stringent with their dealings with regard to a side pocket as a default would be dealt with very strictly.
Understanding side pocketing with an example
When a portfolio is segregated in two parts- original and side pocket, to different NAVs are exist for the same scheme. One NAV is for the original fund and the other one for side pocketed funds.
Now let us say a liquid fund PUV has an AUM of Rs. 1 Crore as of July 2019. In August, the ratings of a bond ABC gets degraded and fall to junk. The liquid fund PUV has an investment of Rs. 10 lacs in these ABC bonds and finally decide on to creating a side pocket the ABC bond funds.
Once the side pocket is created, the liquid fund PUV will have two NAVs:
- One for the original Rs. 90 lac under the existing fund
- One for the newly created side pocket of Rs. 10 lac
The trading rules also will change for both cases. For the original fund investment that has a total AUM of Rs. 90 lacs will be traded as it would be before the creation of the side pocket but with a new NAV.
However, investors will not be allowed to trade the funds that are under the side pocket. The investors will be allowed to redeem or further trade these investments only after the fund house manages to sell off the ABC bonds.