Decoding Side-pocketing in mutual funds!

Side-pocket, as literally explanatory, is a provisional pocket to cast aside a certain fraction of the total funds available – in our context, to the mutual fund.

Side-pocketing as a concept was first brought into mainstream discussions in 2015 when Amtek Auto’s credit rating was downgraded by several notches and was classified as a potential default. At the time, JP Morgan AMC had significant exposure to Amtek Auto’s debt instruments and the investors incurred heavy losses on account of the write-off in value. Now, such negative returns triggered panic and heavy redemptions by investors – now, as you can imagine, Amtek Auto’s securities were illiquid (could not be sold since there were no buyers) and the AMC had to start offloading good & liquid instruments to meet redemption requirements and as a result, the proportion of good to bad securities dropped and the AMC was left with a larger exposure to the bad assets – practically causing a run on the system. Though JP Morgan tried freezing redemptions, but the regulator did not permit such a restriction. This led to discussions around the possibility of mutual funds creating a side-pocket.

The concept of side-pockets has become more relevant to mutual funds after the recent credit default by IL&FS which had far-reaching effects, which continue to linger. Many debt funds’ NAV was marked down as fund houses decided to write-off the value per conservative and prudent judgment at the time of default – this led to significant losses for investors and an unfair advantage to new investors who invested in the fund after the write-off as they get to participate in any recovery made on the defaulted holdings without taking a hit during the write-off.

Side-pocketing basically carves out the bad assets from the main scheme and is held separately in a close-ended fashion till losses are salvaged (separates units to be issued to investors of the main scheme) while the main scheme is adjusted and continues to operate with good assets.

Here is a simple illustration of how side-pocketing works & helps in case of a negative event:

Side-pocketing

Side pocketing ensures that the bad exposures have been carved out and business continues as usual in the main scheme (now with only good assets) while investors having exposure to bad assets stand to benefit from the recovery/salvage if any.

While SEBI earlier wasn’t in favour of side-pocketing as a practice earlier given the expectation of complacency in risk management and probability of abuse by way of using this as a carpet to shove “dirt” under, times have changed and SEBI seems to have acknowledged the fact that governance can be ensured through multiple appended measures, but the practice stands to benefit retail investors the most. Though the risk of moral hazard continues, SEBI has approved the idea of creation of side pockets (segregated schemes) subject to specific approval while it continues to tighten the norms for such provisioning and enabling.

This move is expected to benefit retail investors the most.

Aditya Birla Sun Life, Sundaram Mutual Fund and Reliance Nippon Life Asset Management Company have acquired SEBI approval for a side-pocketing (segregated scheme) provision while Tata AMC has implemented side-pocketing for its treasury advantage, medium-term and corporate bond fund.

Most AMCs seem to be avoiding implementation of the segregated portfolio provisioning. A major reason could be that segregation of a portfolio is an amendment in fundamental attribute and is statutorily required to offer investors a 30-day exit load-free exit window – and chances are that such a window may incite sizeable redemptions given the already negative sentiment.

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