Understanding Side Pocketing in Mutual fund

The collapse of the Infrastructure Leasing & Financial Services (IL & FS) group in September 2018 sent shockwaves to the Indian investor community. It triggered several effects on the Indian economy, such as a lack of infrastructure funds and a sharp downgrading in credit assessment.

The IL & FS debt default sparked a liquidity crisis across the pockets of numerous non-bank investors and financiers. Amidst all this chaos, the term side-pocketing by mutual funds started making rampant rounds. The concept thus became relevant and quite mainstream in recent times. 

Many investors do not understand the concept of side-pocketing or what it means for their mutual fund holdings. The regulatory authority SEBI has recently permitted side-pocketing to protect the interests of the investors. 

Let us take a closer look at side pocketing and how it impacts the holdings in mutual funds.

What is side-pocketing?

Side-pocketing is a mechanism that allows mutual funds to segregate the bad assets in a separate portfolio within their debt schemes. It is a framework to separate the assets that are distressed, illiquid, and difficult to value from other liquid assets in a portfolio. Side-pocketing prevents the bad assets from negatively affecting the returns of the rest of the portfolio.

How does side-pocketing work?

Side-pocketing essentially involves the segregation of the mutual fund portfolio into the main portfolio and a segregated portfolio in case of an adverse (credit) event. The event triggering the segregation can be anything. For example, the down gradation of a bond in a mutual fund portfolio below the investment grade by any credit rating agencies (CRISIL, ICRA, etc.) leads to a sharp drop in the NAV.

Let us try to understand this with an example:

Consider an investor holding 1,000 units of a mutual fund at the NAV of Rs. 20 (portfolio value = 1,000 units x Rs. 20 per unit = Rs. 20,000).

• One of the bonds in the portfolio, which contributes Rs. 3 to the NAV, finds itself downgraded and contributes Rs. 2 to the NAV now. Therefore, the portfolio value of the investor drops from Rs. 20,000 to Rs. 19,000. 
   
• The asset management company (AMC) separates the distressed bond into a separate portfolio, and the rest remains intact in the main portfolio. 
   
• Consequent to this, the investor gets 1,000 units in both portfolios. The main portfolio will have a NAV of Rs. 17 (Rs. 20 total – Rs. 3 of the bond), and the distressed/side-pocketed portfolio will have a NAV of Rs. 2. 
   
• So, you see, the investor value does not change because of the separation.

Main portfolio = Rs. 17,000

Side-pocketed portfolio = Rs. 2,000

Key points to remember:

• Trading, i.e., buying and selling, is allowed only in the main portfolio. 
   
• The investors are not permitted to redeem the segregated portfolio with the AMC. They will get their money back only when the AMC can recover the money from the bond-issuing company.

How does it help?

Investors of debt mutual funds include not only retail investors but also institutional investors. Recent times have seen credit events that have led to some debt mutual funds witnessing a sharp fall in their NAV in a single day. 

Such events fuel the institutional investors to start redeeming their holdings, and the fund manager is forced to sell good investments in the portfolio to meet the redemption. In the end, the retail investors are left with a portfolio with a higher concentration of the downgraded/distressed/lower quality bond.

However, through side-pocketing, all the investors will be treated the same on the day of the credit event. The same treatment implies that no investment/redemption will be permitted until the side-pocketing process is complete.

What are the risks involved?

Investors cannot freely redeem the units of a side-pocketed portfolio with the asset management company (AMC). They will get their money back as and when the affected company pays it back. Although there is no guarantee with regards to the amount of money that may be recovered from the defaulting company.

SEBI has suggested an indicative list of safeguards to be implemented by the AMCs, so the side-pocketing framework is not misused.

Side-pocketing is essentially carried out to stabilize the NAV of the main portfolio in case of a credit event and prevent large panic-driven redemptions in the fund.

Impact of side-pocketing on the investors

• Side-pocketing provides benefits to the investors by selling liquid investments and staying invested in risky funds until the risky funds start generating healthy returns. Whenever the risky funds generate returns, they are passed on to the investors. Therefore, side-pocketing leads to the liquidity of the investments that have suffered a credit downgrade.
   
• Side-pocketing is smoothening various hassles associated with risky investments. Earlier, investors used to exit the funds that faced down gradation. Side-pocketing has changed this scenario dramatically, enabling the investors to remain invested in illiquid assets. The original unitholders are reimbursed whenever these assets begin generating returns. 
   
• Investors are not permitted to subscribe/invest in bad investments and can only pursue healthy assets. 
   
• For the investors that remain invested, side-pocketing protects their interest because the quality assets are not sold consequent to a drop in the NAV. The investors who exit, get an accurate NAV, which reflects the value of the liquid assets.

Impact of side-pocketing on the AMCs and fund managers

• Credit events trigger panic redemptions by investors, and the fund managers are forced to sell quality investments to fulfil the redemptions. However, because of side-pocketing, the perception of bad investments is removed from the equation and limits the fund redemptions by the existing investors. 
   
• Side-pocketing helps fund managers to navigate the redemption pressure better and protect all other investment holdings from being impacted. Side-pocketing insulates the rest of the portfolio from the bad investments. 
   
• As we’ve already discussed, side-pocketing lowers the redemption for the fund managers who can now focus their efforts on recovering the investments made in illiquid assets. And they can do so without unnecessarily adding the pressure of other investors.

Is side-pocketing mandatory?

As of now, side-pocketing has not been mandated by SEBI. AMCs, at their discretion, can implement side-pocketing. Several AMCs have now enabled side-pocketing in their debt and hybrid mutual fund schemes; which means they can now implement side-pocketing in case of any credit events in these funds.

The Botton Line 

Side-pocketing has developed global recognition as being one of the best techniques for protecting investor interests in mutual funds. However, it is slow in finding a steady footing in the Indian mutual funds industry. Several mutual funds still prefer to either freeze fresh cash inflows or impose heavy exit loads on the fund to impose a cost on fund traders. 

Adoption of side-pocketing would eventually result in safety and the smooth functioning of the fund where the investors would not have to resort to panic redemption in times of credit events. The fund houses will also be prevented from getting an undue advantage.

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Happy Investing!