Mutual fund industry trade body AMFI has moved markets regulator Sebi to allow funds with exposure to bonds issued by troubled financier IL&FS to use ‘side pocketing’. Popular in developed markets, side pocketing is an accounting process used to insulate especially small investors from being hit by sudden exits of large investors from exposed funds.
The process involves a fund segregating papers that are in default and illiquid from all other bonds that are perfectly liquid, thus creating two funds — one containing only the bad papers, and the other holding the good ones. Sources said Sebi is currently looking into AMFI’s side-pocketing proposal “with a positive approach”, but is concerned about the moral hazards relating to the process in the long run (giving leeway to fund managers to take extra risks). When IL&FS defaulted on one of its bonds for the first time, the MF industry together was holding its papers worth about Rs.2,700 crore. In developed countries with well-established debt markets, side pocketing is often used by hedge funds and alternate investment vehicles, but not by mutual funds.
Usually, such a solution is warranted by the following scenario: Say, a fixed income fund with a corpus of Rs.100 crore had about Rs.5 crore worth of IL&FS debt, which goes into default. The balance Rs.95 crore is held in good papers, which are liquid. However, in most cases like these, large investors rush and redeem their money from the fund to avoid any further loss. And to meet such sudden redemptions, usually fund managers are forced to sell good papers, while the bad papers, mainly because of illiquidity, remain in the fund itself. This, in turn, leads to a sharp drop in the NAV of the fund, which hits existing investors, mostly small and retail investors. In addition, a large selloff in good bonds may also impact the broader bond market with prices of others also being hit.To insulate small and retail investors from such losses, the fund may segregate the debt papers of IL&FS into a separate fund, while the rest of the good papers remain in the original fund, thus the good portfolio is almost unaffected by the bad papers. All the investors of the original fund will also get units of the side-pocketed fund. And as and when IL&FS pays back, these investors will get their money back.
Such a process could give confidence to large investors to remain invested in the fund and the fund manager, in turn, will not be forced to sell good papers in the market, which will also help in limiting the IL&FS contagion from spreading.
Sebi officials are keen to insulate small and retail investors from such incidents in future, but are concerned whether allowing side pocketing could give leeway to fund managers to take extra risks. “It’s a moral hazard that Sebi is concerned about,” a source said. During 2013, when Amtek Auto had defaulted on its loans, which had hit J P Morgan MF hard, Sebi had declined to allow side pocketing, citing the same reason.
To sum it up…..
What is a ‘side pocket’ option?
A ‘side pocket’ option allows a fund house to separate bad assets or risky ones from other liquid investments in a debt portfolio which could get impacted by the credit profile of the underlying instruments. Using this accounting process, small investors can be insulated from being hit by sudden exits of large investors. Side-pocketing helps stabilise the NAV and reduces redemptions in the scheme. In case the illiquidity event is sudden, side-pocketing provides a cushion to the liquid portfolio.
What is the process?
The process involves a fund segregating papers that are illiquid or in default category from all other instruments in the portfolio that are liquid. This creates two schemes — one containting the illiquid paper and the other holding the good ones.
Why is this useful?
A fixed income fund with a corpus of say ₹1,000 crore has exposure of say ₹60 crore in a defaulting company. The balance ₹940 crore is held in good companies. Due to the default, large investors prefer to redeem their money from the scheme to avoid any further loss. To pay these investors, fund managers are forced to sell good paper, while the bad papers, because of the illiquidity and no buyers, remain in the fund itself. The percentage holding of bad assets in the total portfolio rises. This often leads to sharp drop in the NAV which hits investors. To prevent such a situation, the fund may segregate the debt papers of the affected company, while the rest of the good papers remain in the original fund and thus the good paper is unaffected by the bad papers. All the investors of the original fund will also get units of the side-pocketed funds. As and when the affected company pays back, the investors will get their money back.
What are the disadvantages of side pocketing?
Side pocketing should be used with caution. Since valuations of the illiquid or defaulted asset is contentious, NAV of the illiquid asset will not be discoverable. In addition, two sets of NAVs will be difficult for investors to track. Further, the fund house should not misuse side pockets to protect managers’ fees on the more liquid assets or to hide poorly performing assets or poor liquidity management by its fund managers.