How side pocketing impacts mutual fund investors3 min read . Updated: 19 Jan 2019, 08:45 PM IST
- Side pocketing was earlier prevalent in overseas markets
- It has been introduced in India only recently
The Securities and Exchange Board of India (Sebi) has allowed fund managers to side pocket selected securities. To provide ‘fair treatment to all investors in case of a credit event and to help them deal with liquidity risk’, Sebi has permitted the creation of segregated portfolio of debt and money market instruments by mutual funds schemes, according to the circular.
Why the change
Side pocketing was earlier prevalent in overseas markets but it has been introduced in India only recently. These securities that will be side pocketed are mainly the ones that are down rated and may have defaulted: such securities will then be segregated into a separate pocket so that the existing funds do not suffer, said Nilesh Shah, managing director of Kotak Mahindra Asset Management Company. Before side pocketing, non-performing asset recognition norms were in place, which required a long process to recognise the security as an NPA after the downgrade.
“With side pocketing, the segregation can happen the next day after the downgrade," said Dwijendra Srivastava, chief investment officer-debt, Sundaram AMC Ltd. This concept was first implemented by multinational investment banking firm, JP Morgan in the JP Morgan-Amtex Auto case. New Delhi-based automotives manufacturer Amtek Auto Ltd was downgraded in August 2015. A couple of debt funds of JP Morgan faced big hits in their net asset value, which forced the firm to temporarily suspend redemptions in the particular security. At that time, Sebi did not have any rule prohibiting a pause on redemptions. The fund created a side pocket with Amtek Auto and by December 2015, JP Morgan was able to sell the entire holding in Amtek Auto. The proceeds were credited to the investors.
In case of a credit risk event, the downgrade in credit rating has to be done by a Sebi-registered Credit Rating Agency (CRA). The said security will be side pocketed if it is downgraded to below investment grade. In case of difference in rating by multiple CRAS, the most conservative rating will be considered. For example, if a security has been rated as BBB+ by one AMC and AA- by others, then BBB+ will be considered, said Srivastava.
Side pocketing will happen at the discretion of the AMC. The process outlined by Sebi is such that once the downgrade has happened and the AMC decides to segregate the portfolio, trustee approval has to be sought. Once the approval has come in, the AMC has to issue a press release, disclose the net asset value of the segregated and the main portfolio, intimation to the unit holders. Also, the regulator has said no redemptions and subscriptions will be allowed in the segregated portfolio. AMCS are not allowed to charge investment and advisory fees on the segregated portfolio. However, TER, excluding the investment and advisory fees, can be charged, on a pro-rata basis only upon the recovery of the investments in segregated portfolio. The Sebi circular has ensured the provision is used only in extreme cases of default as the norms are very stringent, said Radhika Gupta, chief executive officer, Edelweiss Asset Management Ltd.
How it will affect fund houses and you
The recent circular will give the fund managers some time to clear the dues and pay the investors, said Shah. In order to avoid misuse of segregated portfolio, Sebi has asked the trustees to ensure a mechanism is in place. “Before side pocketing, in the event of a downgrade, the asset value of the entire fund went down because of which the investors suffered a great deal but now, when the defaulted security will be side pocketed, it will give investors time to recover their dues," said Shah.
It essentially splits the scheme into two, Gupta said. Side pocketing has been made optional for fund houses although it should have been made uniform across fund houses, said Srivastava. “A uniform rule on portfolio segregation works better because given a robust process of credit selection it will give immediate liquidity and comfort to the investors of the affected portfolio."