It is not far off the mark to say that side-pocketing has mostly been side-pocketed by the MF industry.
Post IL&FS crisis, SEBI issued a circular on ‘creation of segregated portfolio in mutual fund schemes’ popularly known as side-pocketing on December 28, 2018.
Side-pocketing is a practice in which fund houses can segregate risky assets from the rest of their holdings and cap redemptions. Simply put, fund houses can create two funds – one with risky assets where the fund house will not allow redemption expecting recovery from stressed assets and another fund with other assets with existing features. This practice is quite common among hedge funds in developed markets.
The advantage of such a practice is that as and when there is recovery from the bad asset, only the erstwhile investors who took the hit earlier are entitled to get the recovered amount if any.
However, SEBI has kept it optional for fund houses. SEBI said, “Creating segregated portfolio may be optional for mutual funds but approval of trustees is necessary for activating such a portfolio. It should be created only if the Scheme Information Document (SID) of the scheme has provisions for segregated portfolio with adequate disclosures.” This essentially indicates that existing fund houses are required to make changes to their SID to avail of this facility. Also, fund houses will have to serve notices to unit-holders well in advance and offer an option to exit the fund without exit load.
Let us see what has happened in the debt market post IL&FS. Two groups are facing difficulties in meeting obligations to mutual funds: (a) Essel group entities in the form of Loan against Security (LAS) exposure and (b) the recent event of Reliance Home and Reliance Commercial. To be noted, DHFL has not defaulted yet, they have only been downgraded. Remember, the use of side-pocketing is not compulsory, it is just an option to mitigate risk. The management of AMCs and trustees act in the best interest of unit-holders and if required, they will resort to side-pocketing.
However, hardly any AMC has made changes to create a segregated portfolio through side-pocketing despite a series of credit events. For some reason, the management of AMCs are not in a position to consider this as an option.
So what is holding them back? The possible reasons why AMCs are not interested in the concept of side-pocketing are:
- The apprehension that when sentiments are disturbed, a communication from AMCs on creating a segregated portfolio for stressed assets may send the wrong signals. The unit-holders may ask, what is it in your portfolio that may go wrong? Don’t you have confidence in your portfolio that you want to a separate portfolio? Since side-pocketing would be a change in fundamental attribute, fund houses will have to give one month no load window to unit-holders giving them an option to exit, which may potentially shift business to competition.
- From AMC’s perspective, apart from credit risk funds, there is no credit risk in other debt funds. AMCs may not see any real need to create a segregated portfolio.
- The SEBI circular said, “The existence of the provisions for segregated portfolio should not encourage the AMCs to take undue credit risk in the scheme portfolio. Any misuse of the provisions of segregated portfolio, would be considered serious and stringent action may be taken.” It may not be correct to say that mere existence of the clause would make the fund manager reckless and encourage him/her to take undue credit risks in the portfolio. However, if the SID comprises a side-pocketing clause, some investors may conclude that the fund manager of the scheme would take undue risks.
- Finally, there will be a first mover disadvantage i.e. if nobody else is doing it, why should we. AMCs may not be keen to take the first step.
Had SEBI allowed fund houses to create side-pocketing without making any amendments to the SID, we might have seen one or two fund houses creating segregated portfolios to protect investors.