How Side Pocketing Affects Mutual Fund Houses and Investors

The SEBI circular that makes ‘side pocketing’ of mutual funds mandatory has raised several questions about the term and its impact on mutual fund investments. Read on to know about mutual fund side pocketing and how to invest in mutual funds, specifically hedge mutual funds.

What does ‘side pocketing’ in mutual funds mean?

Before we discuss the effects of mutual fund side pocketing on fund houses and investors, let’s talk about the basics first - What is mutual fund side pocketing?

Side pocketing in mutual fund investments enables investors to segregate cash holdings and mutual fund units in a debt portfolio from risky illiquid investments. This ensures that the capital invested in high-risk mutual fund schemes are locked, buying time for the fund to recover the invested capital. The liquid assets can be redeemed by investors. In short, it controls liquidity risks.

SEBI (Securities and Exchange Board of India) has made side pocketing of certain securities mandatory for fund managers to control the rising instances of defaults like Infrastructure Leasing and Financial Services (IL&FS). This initiative will, in turn, have an impact on liquid mutual funds holding IL&FS securities amounting to Rs. 2,800 crore.

What’s in it for fund managers?

• Separating the illiquid and risky mutual fund units from the gainful ones enables the fund managers to keep a closer watch on the former as they need more attention. It helps them in tracking and analyzing them better and giving them a greater push towards improving their performance.
• Mutual fund side pocketing enable fund managers to aim for stabilizing the fund performance to achieve maximum returns.
• Analyzing and predicting the NAV is a challenge, even for the most experienced fund managers. This is because there is no tested rule that enables them to accurately predict the NAV of the illiquid and risky assets.
• Ring-fencing risky mutual funds help fund managers tackle redemption pressures better, while ensuring that the other liquid and cash holdings are not adversely affected. This gives them enough opportunity to focus on recovering the capital of the investor who has defaulted on payments. And that too, without unnecessarily adding to the pressure of the other investors.

How does it benefit investors?

• One of the main focuses of side pocketing is to prevent a new investor to take undue favors from the investments of a previous investor. Side pocketing offer investors the benefit of selling the liquid investment and staying invested in the risky funds till they generate healthy returns. If these risky bets generate returns, they are passed on to the investors. Thus, side pocketing may lead to liquidity of investments showing a downgrading rank.
• Side-pocketing is easing the hassle that once accompanied risky investments. Previously, investors would exit funds with downward ranks to achieve returns at a higher NAV. Side pocketing is changing this scenario drastically, enabling investors to remain invested in the illiquid assets. After these assets generate returns, the original unitholders will be reimbursed.
• The evaluation of the investment realization has become tougher because of side-pocketing. The returns realized from liquid asset investment is easy to calculate on the basis of the existing NAV, the same cannot be said about evaluating the returns from illiquid assets. As discussed before, predicting the NAV of illiquid investments is no game. The investor will have to stay invested and hold their breaths till the investments offer returns.

Sebi is introducing measures to ensure that the provision is not misused and fund managers do not become reckless. It is yet to notify them, but people familiar with the matter say a fund manager may need the clearance of the board of trustees before investing in such risky assets; the performance of the scheme may also be monitored by the board. Fund managers will be able to use the facility only in select credit events such as in the case of a default in interest payments by the issuer.

Salient points about mutual fund side pocketing at a glance

• SEBI has made mutual fund side pocketing compulsory to avert liquidity risks by separating money market and debt instruments from illiquid investments.
• This segregation, which is done when there is a rating downgrade of a mutual fund scheme, allocates the units to the existing investors on a pro rata basis.
• The NAV of the mutual fund then reflects the value of the liquid holdings, and assigns a separate NAV to the side pocket mutual funds.
• Only the investors who were invested in the mutual fund at the time of the rank downgrade benefits from the future recovery and growth of the fund.

Everything has its share of pros and cons, and side pocketing in mutual fund investments is no different. However, investment experts believe that it has more good in store for both fund houses and investors. Therefore, SEBI’s recent decision, passed in December 2018, in making side pocketing mandatory for certain mutual fund schemes is a step towards the right direction.

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