Home >Money >Personal-finance >Will investors benefit if Sebi allows MFs to side-pocket toxic assets?
Side pockets are mainly used by hedge funds but recently have been used by at least two fund houses in India. Photo: Reuters
Side pockets are mainly used by hedge funds but recently have been used by at least two fund houses in India. Photo: Reuters

Will investors benefit if Sebi allows MFs to side-pocket toxic assets?

Sebi is considering a proposal to allow side pockets

A side pocket allows fund managers to remove a toxic bond from the rest of the ‘good’ assets of a mutual fund. Side pockets are mainly used by hedge funds but recently have been used by at least two fund houses in India. Sebi is considering a proposal to allow side pockets. But does it work for investors?

AMCs should not use it routinely: Aashish P. Aomaiyaa, Managing director and CEO, Motilal Oswal Asset Management Co. Ltd

Side-pocketing is critical for a scheme where an underlying fixed-income investment has turned non-performing and hence illiquid. Non-performing assets in mutual funds which are pass-through and subject to redemptions or maturities cause challenges for valuation of the scheme. While an underlying instrument may not pay proceeds timely but post a resolution process the amount due could be paid in part or full. Side-pocketing allows the fund to set aside such assets and split the NAV and units into two parts thereby issuing separate units in lieu of only the assets gone bad, while the rest of the scheme continues with balance units, accurate NAV and liquidity.

Once there is a resolution, payouts that are received are to the credit of investors who have been issued separate units in lieu of those assets while other investors who never had any exposure do not get undue benefits from any future repayments. I don’t see any negative to this arrangement except that it should not be viewed by AMCs as a routine fall-back option while assuming risk exposures in their portfolios.

—As told to Sunita Abraham

It can safeguard retail investors: Radhika Gupta CEO, Edelweiss Asset Management Ltd

Introducing side-pocketing in mutual funds is broadly an investor friendly move. It allows funds to set apart illiquid assets in the event of an extreme event, and manage the cascading effect on the fund because of a single security. In the past when such events have happened, investors who stayed invested have had higher risk due to high concentrations of a single security, and often they are retail investors. Side-pocketing will allow AMCs to safeguard their investors, and also have time to take informed decisions when there are extreme credit events, which have happened and can recur as our debt markets grow.

Globally, side-pocketing is allowed in many markets, with conditions attached. As a caveat, side-pocketing in India should be allowed only in extreme cases—sharp downgrades below investment grade, in certain kinds of open-ended schemes, and post trustee approvals. This will ensure the provision is not misused to take undue risk, and used only in a black swan event.

—As told to Sunita Abraham

It will lock only part of investors’ money: Suresh Sadagopan Founder, Ladder7 Financial Advisories

Whenever there is illiquidity or a crisis or when the price of an instrument falls dramatically, it can affect the overall valuations of a mutual fund. Therefore, they are seeking to deal with such instruments or investments separately. So whatever goes in to the side-pocket won’t be allowed for redemption. The original scheme will be broken into two and while the original scheme will be allowed for redemption, people will have to wait for recovery to happen for that portion of investment that has gone into the side pocket. 

In such situations it is not that the money is irretrievably lost. Sometimes there can be temporary mismatches or defaults. There could also be some other crises and given time, some of these do get sorted out. 

Largely, it is definitely a good move. Instead of locking the entire mutual fund due to one issue, you are locking only a small portion in the side-pocket. You will get the money in the side-pocket as and when the problem gets resolved. But we will have to see what will be Sebi’s interpretation.

—As told to Shaikh Zoaib Saleem

Sebi can step in to ensure disclosures: Amol Joshi Founder, PlanRupee Investment Services

Side-pocketing could be an effective way of separating defaulting and illiquid assets till dues are realised partially or fully. A side-pocket ensures that liquidity is not choked for investors holding the units of the main scheme. Nor will a retail investor be at a disadvantage because he is slow to absorb the news and react, and other investors are quick to redeem with full value if the fund house chooses to make a good redemption from other assets. The gradual mark-down leaves a chance that some investors will get a better deal than others.

Globally, the biggest objection to side-pocketing is evaluating the security in the absence of liquidity and hence the fees that an asset manager can charge on it. An Indian AMC that recently faced such a credit event lowered the total expense ratio to almost zero, giving an answer to the dilemma. Another objection is that the asset managers would become reckless in terms of taking exposure with the safety net of side-pocketing available. The regulator can step in and ensure that the side-pocket valuation dip in NAV reflects in the mandatory performance disclosures.

—As told to Nilanjana Chakraborty

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