Ever since IL&FS defaulted on its debt papers and sparked a liquidity crisis across various pockets of non-bank financers, side-pocketing by mutual funds has become a a commonly used term. Though the concept has become quite mainstream in the recent times, not everybody understands the idea and what it means for their holdings with mutual funds. Let us take a closer look at how it impacts investor holdings in mutual funds.
Understanding the Concept
Assume you are carrying a bunch of Rs. 100 notes - all good ones. You spend the notes as and when necessary. Whenever you get the next pocket money, you add it to the same bunch of notes. All the notes are kept in the main pocket of your jeans.
Now, you realise that one of the notes is in a pretty bad shape and may become unusable if it continues to be a part of the main bunch, since you have to use this bunch almost every day for buying your regular stuff.
What would you do with that note?
The simple and logical thing to do in such a case would be to keep that spoiled note in your side pocket and continue to use the remaining bunch from the main pocket for your daily use.
You will also pay special attention to your side pocket - until either the spoiled note is replaced by a good one or has to be thrown off.
Simple, isn't it?
That is precisely what Side Pocketing in Mutual Funds is all about - wherein the fund house moves a part of their investments into a side pocket for special care and attention, since they have not been performing well.
Now, you realise that one of the notes is in a pretty bad shape and may become unusable if it continues to be a part of the main bunch, since you have to use this bunch almost every day for buying your regular stuff.
What would you do with that note?
The simple and logical thing to do in such a case would be to keep that spoiled note in your side pocket and continue to use the remaining bunch from the main pocket for your daily use.
You will also pay special attention to your side pocket - until either the spoiled note is replaced by a good one or has to be thrown off.
Simple, isn't it?
That is precisely what Side Pocketing in Mutual Funds is all about - wherein the fund house moves a part of their investments into a side pocket for special care and attention, since they have not been performing well.
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.
How is Side-Pocketing technically done?
Side pocketing is considered as a change in the fundamental attributes of a scheme.
This requires an asset management company (AMC) proposing to 'create' a side pocket to amend the scheme information document (SID) and allow an exit window of 30 days without charging any exit load.
Once this permission is taken on the day of the event, the AMC can segregate papers that are illiquid or in default category from all other instruments in the portfolio that are liquid.
This creates two schemes or accounts — one that contains the illiquid paper and the other holding the good ones.
Once the side pocket is created for the first time, the 30 day window is not required to be notified any other time if some investments need to be moved to the side pocket. Both accounts are legal and credible investment accounts, but regulatory authorities closely monitor the side pocket accounts.
What happens when an investment enters a side pocket account?
Once an investment enters a side pocket account:
- Only the current participants in the fund scheme are entitled to a share of it.
- Future investors will not receive a share of the proceeds should the asset's returns become realized.
- All existing investors in the scheme will receive one new unit in the side-pocketed portfolio in addition to each of their existing units in the scheme.
- No transactions are allowed in these new side-pocketed units. So, if you redeem the fund after side-pocketing, you will only receive the NAV of the main portfolio. But if the scheme eventually recovers money from the bond, they will get automatically redeemed and you will receive a payout. The trustees of the AMC are supposed to monitor the recovery of proceeds in the side-pocketed bonds.
- Investors who leave the fund may not be able to redeem their side pocket investment from the fund immediately. However, they receive a share of the value when the assets are liquidated or relocated to the general fund.
What if Side Pocketing is not done?
A fixed income fund that has a corpus of Rs 1,000 crore with a 5 per cent exposure to a company that defaults. Due to this default by one company, many large investors tend to redeem their money from the scheme to avoid any further loss. To pay them, the scheme is forced to sell good paper, and thus the percentage holding of bad assets in the portfolio rises. This results in further withdrawal demands and the viscous cycle continues. By segregating the bad asset, investors do not rush in to redeem. As and when the affected company pays back, the investors will get their money back.
Writing down Vs Side Pocketing?
Writing Down is like throwing away that damaged note, instead of keeping it in your side pocket - giving up all hopes of its usability.
When debt funds write down the value of a bond, they usually aren’t sure if the bond is a complete dud or will realise some value later. But in the interests of conservatism, SEBI rules require funds to write down the value of such bonds by 25, 50, 75 or even 100% in their portfolios, based on their credit ratings. When a fund takes such write-downs, the NAV takes an immediate blow. But if the issuer of the bond later pays up his dues, the fund will then have to increase its NAV to account for the repayment. In such cases, investors in the scheme who exit early taking NAV losses would fail to benefit from the recovery.
On the other hand, new investors who entered the scheme after the write-down would stand to pocket unfair gains on a bond they never owned.
Segregating downgraded bonds in a fund’s portfolio into a ‘side-pocket’ avoids such unfair treatment. When a scheme side-pockets a doubtful bond, any recovery from the bond is distributed to all investors who were invested in the scheme when the downgrade happened. Investors who got into a scheme after the downgrade, get to buy only into the main portfolio excluding the doubtful bond.
Merits of creating a Side Pocket Account
- Separates illiquid and liquid assets.
- Shields fund returns from distressed assets. It helps small investors from being hit by sudden exits of large investors.
- Simplifies accounting and administration. Regulatory authorities closely monitor the side pocket accounts.
- Limits fund redemption. It helps stabilise the net asset value (NAV) and reduces redemption in the scheme. If the illiquidity event is sudden, side pocketing provides a cushion to the liquid portfolio.
- Side Pocketing makes the price discovery of the bad assets a transparent procedure with investors having the freedom of either selling it at prevailing price or holding it if they expect the value to recover in future.
Demerits of creating a Side Pocket Account
- Delay in redemption.
- Prone to misappropriation. Analysts point out that since valuations of the illiquid or defaulted asset is contentious, NAV of the illiquid asset will not be discover-able.
- Can be open to incorrect pricing.
- Not shared by new investors.
- Investors will often find it difficult to track two sets NAV.
- The fund house should not misuse side pockets to protect managers’ fees on the more liquid assets or to hide poorly performing assets or poor liquidity management by its fund managers
Is creating a side pocket compulsory?
SEBI has not made side pocketing compulsory for all bonds that turn non-investment grade. This decision is left to the discretion of the AMC and its trustees. So, when a bond slips into non-investment grade, some AMCs may write down its value, while others may side pocket it.
When and what kind of bonds are debt funds supposed to segregate?
SEBI rules allow debt funds to side-pocket only those bonds that are downgraded below investment grade by rating agencies. When a bond rated BBB or above is pegged down, it turns from an investment grade bond to a non-investment grade one. Fund houses are required to decide on side-pocketing and secure the approval of their trustees for it, on the day the downgrade happens.
When a bond is downgraded, why do some fund houses announce side-pockets while others don’t?
SEBI has not made side-pocketing compulsory for all bonds that turn non-investment grade. This decision is left to the discretion of the AMC and its trustees. So, when a bond slips into non-investment grade, some AMCs may write down its value and hang on, while others may side-pocket it. Where there’s no side-pocketing, if you exit the scheme after the downgrade, you won’t receive any benefits if there’s a recovery.
AMCs are offering a one-month exit window. Does this mean the scheme will take a hit from a bad bond? Do I need to exit it?
No, you shouldn’t. The is only an enabling provision that tells you that the scheme may, in future, use side-pocketing for some of its debt schemes if they take a hit on their bonds. When MFs make changes to their fundamental attributes, SEBI rules require them to give their investors a one-month exit window (without load). Given that SEBI’s side-pocketing rules are recent and most AMCs are introducing this feature into their debt funds for the first time, they have been advertising and offering investors a one-month exit window. Once all fund houses incorporate these enabling provisions into their scheme attributes, they can go ahead with side-pocketing in future without seeking the okay of their investors.
How will you know if a debt scheme is creating side-pockets?
On the day a scheme decides to side-pocket a bond, it is required to issue a press release and send an SMS as well as email to all its investors. It must also inform investors as soon as it secures trustee approval for this. On the day the announcement is made, all new purchases or sales of units in the scheme are frozen.
How do I know if a debt fund you are going to invest in has side-pockets?
SEBI rules require all debt schemes to disclose the details of side-pocketed or segregated portfolios prominently with the scheme name in their advertisements, scheme documents, application forms and websites.
Can the side pocket rule be misused?
When side pocketing was introduced, a section of market participants felt that it could be misused by fund houses to hide their bad investment decisions. SEBI, however, has put in place checks and balances to minimise any such misuse.
The regulator has said that trustees of all fund houses will have to put in place a framework that would negatively impact the performance incentives of fund managers, chief investment officers (CIOs), etc. involved in the investment process of securities under the segregated portfolio.
So, fund managers know that any creation of such side pocket in the future would also affect their own appraisals and incentives.
Further, SEBI has also said that side pocket should not be looked upon as a sign of encouraging undue credit risks as any misuse of the option would be considered serious and stringent action can be taken.
Most Recent Example of Side-Pocketing
You will see more of Side Pocketing news in the months and years to come, as this novel concept finds its place in the Indian Mutual Fund Industry.
There is no need to panic.
The bad news always used to be there in the past as well. Now, it is just being made transparent.
The most recent example was in Jan 2020 when Franklin Templeton MF side pocketed exposure to Vodafone Idea.
Read the full news here
Summary
Most Recent Example of Side-Pocketing
You will see more of Side Pocketing news in the months and years to come, as this novel concept finds its place in the Indian Mutual Fund Industry.
There is no need to panic.
The bad news always used to be there in the past as well. Now, it is just being made transparent.
The most recent example was in Jan 2020 when Franklin Templeton MF side pocketed exposure to Vodafone Idea.
Read the full news here
Summary
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.
Regards
Manoj Arora
Official Website
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