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Many investors considered debt mutual funds as a safe way of earning good returns on investments. However, the IL&FS crisis in 2018 made them cautious about investing in debt instruments. To safeguard investor interest in debt funds, in December 2018, the Securities and Exchange Board of India (SEBI) approved the creation of a ‘side pocket’ for mutual funds having debt exposure.
This article will discuss the mechanism of side-pocketing in mutual funds and how investors can benefit from side-pocketing mutual funds.
A side pocket is an accounting technique used in hedge funds for separating illiquid and distressed assets from liquid and quality assets from a debt fund portfolio. Illiquid assets are assets that cannot be easily sold, converted or exchanged for cash without incurring a loss in their value. Scarcely traded bonds and commercial papers of companies that have defaulted are some examples of illiquid assets.
Side pocketing in mutual funds thus relates to a segregated portfolio across a mutual fund that holds certain securities impacted by a credit event. A credit event relates to a sudden adverse situation in borrower loan repaying capability, like bankruptcy. Normally, when an asset gets under side pocketing account, only current investors are entitled to its share. Potential investors will not receive any amount if the side-pocketed asset recovers in the future.
By creating a pocket account for mutual funds, fund managers safeguard a scheme’s relatively liquid assets from a credit event. Thus, side-pocketing in mutual funds safeguards investor interest in debt funds.
Distressed assets mean assets that are experiencing any kind of financial or operating distress, forcing the owner to sell them normally below their market value. Bank debt, equity positions and corporate bonds are common examples of distressed assets.
By creating side pocketing in mutual funds, fund managers can split a mutual fund scheme’s Net Asset Value (NAV) into two parts. NAV denotes the market value of the assets in the mutual fund scheme.
One part of the NAV relates to the scheme’s liquid assets, and the other NAV signifies the pocket account’s illiquid, risky or distressed assets, meaning securities. The NAV split ensures that the side pocketing assets have no negative impact on liquidity and valuation of the said portfolio’s liquid or good-quality assets. For instance, if an asset under side pocketing mutual funds gets downsized to junk or default category, the updated status will only impact the NAV of that asset. It will not impact the entire mutual fund scheme.
Consider the below example for understanding how two separate NAVs work for a pocket account mutual fund scheme.
In the event of an asset rating in a mutual fund scheme getting downgraded, fund houses create a side pocketing in mutual funds. Thus, they separate the downgraded asset as a segregated portfolio for the said scheme. Existing investors are allocated assets based on pro-rata in the segregated portfolio (side pocketing).
If the fund house does not apply a side pocketing mechanism, then many investors in the scheme may think of redeeming from the scheme to avoid losses. The fund house would have to sell its liquid and quality assets to pay such investors. This will not only decrease the valuation of the overall scheme but also increase the number of bad assets in the portfolio.
Separating assets that fall under the purview of distressed assets, illiquid securities and risky assets would help fund houses incur a one-time loss only. Also, it would help maintain the value of the fund from decreasing by stopping investors from further redemption of their investments.
SEBI has not made side pocketing compulsory for bonds that get downgraded to non-investment grade. However, mutual fund experts consider side pocketing a better option for downgraded assets instead of having them written off.
Thus, side pocketing in mutual funds ensures that liquidity is maintained and enables better management of the fund.
When side pocketing in mutual funds gets created, it splits from the liquid assets in the scheme. It also gets closed for subscription and redemption. Investors can still continue investing in liquid assets which do not fall under the purview of side-pocket funds.
If the fund house recovers any money from side-pocketed funds in the future, then they pay the amount to the investors of the said units.
Currently, SEBI allows debt mutual funds in India to have side pockets for all stressed securities. SEBI's circular states that fund houses can create a segregated portfolio of unrated debt securities provided such securities show actual default of their principal or interest amount.
Side pocketing is an option that mutual fund houses can initiate on a mutual fund scheme when a credit event occurs. It helps to safeguard investor interest in the debt scheme and ensures better management of the mutual fund scheme. For more details, visit the Moneyfy website.
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