What is side pocketing? Can it help investors of funds stuck with illiquid assets?Liquidity tightening has been the talk of the town over the past couple of months. Troubles in the NBFC sector, led by the downgrade of IL&FS and its subsidiary companies, dented the sentiments of investors and we saw them running to safety. Many investors redeemed their investments when the NAVs of the schemes fell.

As the redemptions in mutual fund schemes increased, fund managers were forced to sell other good instruments in order to meet these cash requirements as the stressed assets became illiquid. To combat the current situation and such instances in future, mutual fund industry has approached SEBI to seek approval for creating a ‘Side Pocket’ of stressed assets.

Side pocketing is a process of segregating bad quality assets thus creating two different pockets and calculating separate NAV for each pocket. These two NAVs would be sub sets of the original scheme wherein the NAV of good quality assets will behave like normal actively managed fund.

Side pocketing in mutual funds

Investors can redeem the portion of their investments present in good quality assets however the portion in the illiquid or bad quality assets will be locked till the resolution (settlement with issuer in full amount or in parts). This measure is practiced globally to deal to illiquid instruments.

How does this benefit?
In a situation where some of the assets turn illiquid, NAV of entire portfolio drops. Liquid part of the portfolio is sold in order to meet the immediate requirement, this in turn, increases the concentration of illiquid assets in the portfolio. In case investors’ exit from the fund, they book losses and will not get any benefit when the money invested in these illiquid assets is recovered.

Side pocketing can stabilise the NAV and protect the good quality portion of the portfolio. It also protects all the investors (retail as well as institutional) as redemption is not allowed till the side pocket is in place. Investors will benefit when the bad quality portion of the portfolio is liquidated.

What are the challenges?
The biggest challenge would be the calculation of NAV of bad quality portfolio as valuations of illiquid instruments could be debatable. Also tracking two NAVs of the same fund would be difficult for retail investors. The other challenge would be ensuring that fund managers don’t take comfort from this and sign up for more risky bets.

Global Context
US allow side pocketing only for hedge funds. In Italy, it’s allowed only for non-retail funds. In UK, side-pockets can be used for alternative investment funds (AIFs) only. On the other hand, Australia, Brazil, France, Hong Kong, South Africa, and Singapore allow side-pockets to be used irrespective of the type of funds.

Industry view
We spoke with CIO of a leading mutual fund who believes if permitted, side pocketing will turn out to be a blessing in adverse credit situations. However, the possibility of this facility being misused cannot be eliminated. Thus, he says, if SEBI permits the use of side pocketing there should be strict regulations for its implementation.

Proposal to SEBI has been submitted early this month and SEBI may take a decision on it in the coming quarter. The prudent use of such measures that have globally been accepted would benefit the investor as well as the mutual fund industry.

Priyanka Bharati

Priyanka Bharati is a senior personal finance analyst with RupeeIQ. She can be reached on priyanka.bharati@rupeeiq.com