What is side pocketing by mutual funds and when does SEBI permit mutual funds to side pocket their mutual fund portfolios?

Last year, after the MF crisis, SEBI permitted side pocketing of stressed portfolios. What exactly is side pocketing and how does it help mutual fund. Typically, debt funds hold an array of debt securities in their portfolio which include government debt, state government paper, treasuries, corporate paper and NBFC paper. These debt papers have different levels for risk. The concept of side pocketing allows mutual funds to segregate such toxic assets and issue units only on the good quality portfolio for fresh investors. For example, BOI AXA Mutual Fund took a hit of nearly Rs.100 crore on its exposure to IL&FS bonds. When the company started defaulting on its bonds, the fund decided to take a total hit of Rs.100 crore in one shot and that impacted the NAV of the fund by nearly 5% in a single day. In such circumstances, the side pocketing would have been a useful concept. Let us first understand how side pocketing works and its implication?

Understanding the concept of side pocketing

Let us go back to the case of IL&FS. Specific funds like DSP and Birla had a fairly large exposure in excess of Rs.600 crore to IL&FS group. In such cases, the toxic portfolio of IL&FS can be side pocketed where the fund will also be permitted to place restrictions on the limit of redemption in a day or in a week. This will reduce the rush for redemptions as we had seen in a number of cases which had led to a contagion effect of other NBFCs also seeing a huge price impact. Such side pocketing will be optional for the mutual funds and prior approval of the trustees of the fund will be mandatory before the portfolio can be side pocketed. Let us look at an illustration of how side pocketing will impact the holdings of an investor with a large exposure to the fund.

Let us say that Company X has invested Rs.10 crore in Alpha Bond Fund with a total corpus of Rs.1000 crore. In other words, Company X investment in the fund accounts for 1% of the total fund corpus. Assume that the fund has issued a total of 1 crore units and therefore Company will be holding 1 lakh units of the Bond Fund. Assume that the IL&FS exposure of Alpha Bond Fund was to the tune of Rs.50 crore. In that case, the Bond Fund will now consist of two sub portfolios; Clean Portfolio and Side Pocketed Portfolio consisting of 95 lakh units and 5 lakh units respectively.

Therefore Company X will now be holding 95,000 units of the Clean Portfolio and 5,000 units of the Side Pocketed portfolio. While the 95,000 units will still be available for redemption at any point of time, the balance 5,000 units under the Side Pocketed portfolio may have redemption restrictions only subject to actual recovery of monies from creditors. This will avoid any sudden redemption pressure on the fund. The fund can also create multiple levels of Side Pockets depending on the risk perception of the fund to make the decision a lot easier for the investors.

Key implications of Side Pocketing of funds

Side pocketing or segregation of assets is more relevant in case of funds that have a mix of good and toxic assets. However, caution is necessary to ensure that fund managers don’t misuse this facility for reducing the redemption pressure. Also it raises a fundamental question over the wisdom of having multiple asset class funds and opportunities funds. Are investors really better off staying off such funds and just focusing on long term and short term government debt funds where the risk of default is zero.

Such a segregation and blocking redemption of a certain class of assets could defeat the very purpose of why investors invest in such funds. There is another side to this argument. If a fund classifies 10% of its assets as side-pocketed and if the trend is across the industry in bad times then it is understandable. The problem could arise if the problem is concentrated in just a handful of funds. In that case, even their good funds could see a run on their AUM. That is not a healthy scenario.

Side pocketing may be a good strategy on paper but the implementation is fraught with risks and regulatory checks and balances are mandatory.