Side-Pocketing: Is it the Best Way to Protect the Interest of Investors?
Dec 14, 2018

Author: Vivek Chaurasia

The memory of the IL&FS crisis is still fresh in the minds of mutual fund investors who held their investment in liquid funds holding the destressed assets of IL&FS and its group companies. Notably, IL&FS and its subsidiaries had defaulted on several debt repayments due to the liquidity crisis.

Following the IL&FS fiasco, I wrote ‘why your money in liquid funds is at risk’. I expected the market regulator SEBI to take some concrete step and frame strict guidelines to stop mutual fund managers from taking unnecessary risk with the hard-earned money of the investors. Unfortunately, not much has been done on this front.

However, as a precautionary measure against such crisis in the future, the regulator has now allowed mutual funds to segregate their holdings in risky debt and money market instruments from the rest of their holdings. In financial market parlance, this practice is referred to as “side-pocketing” and commonly used by hedge fund managers in offshore markets.

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How will ‘side-pocketing’ work for Indian mutual funds?

Side pocketing allows mutual funds to segregate the portfolio of troubled papers in case of a downgrade or default by any issuer. It is an optional facility, which can be utilised only after trustees’ approval.

After segregating the risky assets, the fund can create two set of units. The first set of units will contain its holdings in good assets, while the other set of units will contain the holdings made in destressed, illiquid and hard to value securities, and will be closed for fresh subscription as well as redemption.

Well, with the growth in credit fund segment in future, the regulator expects increase in cases of downgrades and defaults by issuers. As a precautionary measure side-pocketing seems to be a welcome move to protect some interest of retail investors and save them from adverse effect. It will also prevent any kind of redemption pressure on debt funds and will allow the primary portfolio to operate as usual. Thus, allowing fresh subscription and redemption from the primary portfolio.

The secondary portfolio containing troubled papers will be kept aside, and the money will be paid to the unit holders (who take the hit when the credit event happens) if the fund house is able to recover money from these bad assets.

The concern is…

Although the regulator has indicated that it will put various safeguards in place to ensure that mutual fund houses do not misuse the facility, it is yet to be seen how effective this will be.

No strict guidelines exist to restrict mutual funds from taking credit risk in what's meant to be safe liquid funds.

The fund managers can still go overboard on credit exposure to private entities, and will now have a ‘Plan B’ in place, if any of their exposure gets into trouble or takes a hit.

For investors…

Some portion of your money may get locked in. You will not be able to withdraw your entire money if your fund gets into trouble. What if you are just few days away from your goal?

Still, let us wait for the guidelines from the regulator that would prevent fund managers from misusing this facility.

It will be great if the regulator clearly defines the depth of the circumstances under which side-pocketing can be used. In addition, it should also limit the number of times a fund house can use the facility of side-pocketing. It should not be an easy gateway for mutual fund houses to get through their failures.

Is there a better alternative for liquid fund investors?

I will not say all liquid funds take credit risk. There are funds that care for investors.

However, many fund managers seem to have forgotten the basic objective of liquid funds, that is to provide safety to capital along with liquidity. Returns come secondary. However, they have been taking unexpectedly high exposure to private entities in order to generate higher yields. Beware, even top rated and reputed private issuers can default. IL&FS was a top rated issuer, but failed on its commitments.

You, as an investor, need to be cautious while investing in liquid funds. It will be prudent to have a clear objective in mind before committing your money to liquid funds.

Ask yourself, is this money meant for safety or am I looking to generate some returns on it by taking some credit risk?

Your safe money should preferably find its way to liquid funds having almost zero exposure to private issuers. Overnight funds can be another alternative for your safe money, given that they have a mandate to invest in overnight securities having maturity of 1 day, such as CBLOs and Repos. Whereas the money meant for high returns can find its way to other liquid funds or debt funds, based on your time horizon.

Fortunately, the optional facility of side-pocketing may now be able to hedge some portion of your debt and liquid fund investment, in case of crisis.

P.S.: We have just released the 2019 Edition of our popular report ‘Strategic Funds Portfolio for 2025’, backed time-tested investment strategy that many successful investors follow to create wealth. I suggest you get your copy right now.


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