What is Side Pocketing and How it affects Mutual Funds

What is Side Pocketing, and How it affects Mutual Funds?

The mutual fund industry in India is growing at an exponential pace, and as an industry, it is continuously widening its investor base and also increasing its geographical spread. The market regulator SEBI plays an important role in the regulation of the mutual fund industry, protecting the interest of investors at all times and taking adequate measures as and when needed to boost investor confidence in both equity and debt mutual fund schemes.

Side pocketing in mutual funds is one such measure taken by SEBI to protect the interest of investors in debt mutual fund schemes in case of troublesome debt in the portfolio of the scheme.

What is side pocketing in mutual funds?

Side pocketing in mutual funds is the creation of a separate portfolio within the fund’s portfolio for assets that are illiquid, risky or distressed at the moment and have been downgraded by rating agencies below investment grade. Such assets are ring-fenced from the other high quality, liquid assets in the portfolio to protect and treated differently for investment and redemption to safeguard the interest of old as well as new investors in the scheme.

Side pocketing was introduced by SEBI in December 2018 after the IL&FS fiasco, where it failed to meet its debt obligations and repay its lenders and creditors. This, in turn, put significant pressure on various mutual fund schemes that had IL&FS papers as a part of its holdings. The complete mayhem resulted in substantial volatility in the debt and money market instruments resulting in redemption pressure in mutual fund schemes. High-quality, liquid assets in the schemes were sold by the funds to meet redemption requests resulting in increasing the exposure of remaining investors in the illiquid assets. Side pocketing mechanism is allowed only in debt mutual fund schemes.

How does it side pocketing work?

Whenever a debt instrument is downgraded by credit rating agency from an investment grade to a non- investment grade, the mutual funds have an option for creating a side pocket and segregating illiquid assets from the high-quality liquid assets.

The existing investors are allotted units in the leading portfolio and segregated portfolio on a pro-rata basis. No redemption and subscription are allowed in the segregated portfolio. Moreover, SEBI makes it mandatory for the fund to list the segregated portfolio on the stock exchange within 10 days to provide an exit window to the existing unitholders.

Depending upon their outlook, investors can either continue to hold their investment in the segregated portfolio or choose to exit at the prevailing rate. Any future recovery from the illiquid assets is credited in the side pocket portfolio and paid to the unit holder in proportion to his holdings.

Side pocketing impact on mutual funds and AMCs

Side pocketing aids mutual fund schemes from selling quality assets in its portfolio to meet sudden redemption pressure in a panic situation.

Creation of side pockets help insulate the remaining portfolio from troublesome debt

To ensure that mutual funds do not misuse side pocketing, SEBI also suggests a list of safeguards that AMCs may implement.

Benefits of side pocketing in mutual funds

Over the last few months, many debt mutual fund schemes have side pocketing a portion of its portfolio if the ratings of the investment paper in its holdings have been downgraded by the credit rating agency. Side pocketing is important to protect the interest of retail investors in case of illiquid assets because credit defaults accompanied by information asymmetry, results in institutional investors taking advantage of the situation. The benefits of side pocketing in mutual funds include-

It is an important mechanism to ensure stability and reduce volatility in the debt market by addressing the issue of redemption pressure in case of troubled assets

It prevents distressed assets from hampering the returns generated by high quality, liquid assets

At the time of selling the segregated assets, only those investors who have units in segregated assets on the record date are entitled to the proceeds, thus ensuring a fair treatment

• To avoid unfair advantage of lower valuation, fresh inflows are allowed only in the non-side pocketed portfolio
• As side-pocketing helps curb redemptions, it helps in stabilizing the net asset value (NAV) of the scheme

In case of a situation arising due to sudden illiquidity, it provides cushioning to the portfolio.

• The most significant benefit of side pocketing is that all investors, retail or institutional are treated at par
• CONCLUSION

Globally, side pocketing is one of the best mechanisms to protect the interest of investors, and SEBI as a regulator ensures that it takes timely measures and imposes adequate regulations for the AMCs to safeguard the interest of investors at large. If you have any specific query or doubt about side pocketing in mutual funds schemes, contact our experts at IndiaNivesh for guidance.

Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.