Tata Mutual Fund Launches India’s First Mutual Fund Side Pocket: All You Need To Know
Jun 13, 2019

Author: PersonalFN Content & Research Team

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Debt mutual funds are going through a bad phase, so are their investors.

Mutual fund houses are finding it difficult to recover money from troubled businesses and willful defaulters. Overconfidence of fund houses and their fund managers is costing investors their hard-earned money.

However, they are working out different strategies to palliate investors' pain.

Given the unprecedented nature and the severity of the problem, it's still unclear if various tactics used by mutual fund houses to preserve their business and offer investors a way out through debt recovery crisis will pay off.

Side-pocketing is one such practice.

Are you wondering what side pocket is?

In layman terms, side pocketing is an accounting method of calculating two Net Asset Values (NAVs) of a scheme by demarcating good assets from troubled assets. Redemptions and purchases are allowed only through the bucket of good assets.

As and when the issues of troubled assets are resolved, investors can liquidate their holdings in that bucket as well.

Side pocketing is considered as a change in the fundamental attributes of a scheme. This requires an Asset Management Company (AMC) proposing to create a side pocket to amend the Scheme Information Document (SID) and allow an exit window of 30 days without charging any exit load thereof.

Recently Tata Mutual Fund created side pockets in three schemes- Tata Corporate Bond Fund, Tata Medium Term Fund and Tata Treasury Advantage Fund, thanks to DHFL debt conundrum. As DHFL failed to honour its debt repayment commitment, these schemes above witnessed a fall of 29.7%, 12.3%, and 4.1% fall respectively on 4 June 2019.

As on 30 April 2019, Tata Corporate Bond had 36.8% exposure to DHFL papers, whereas Tata Medium Term Fund and Tata Treasury Advantage Fund held 15.1% and 3.1% of their portfolios in DHFL securities respectively.

Table: Damage done by DHFL...

Absolute (%) CAGR (%)
Scheme Name 1 Month 3 Months 6 Months 1 Year 2 Years 3 Years
Tata Corp Bond Fund(G)-Direct Plan -29.31 -28.49 -30.74 -29.71 -13.58 -6.84
Tata Treasury Advantage Fund(G)-Direct Plan -3.34 -2.15 -0.10 3.94 5.30 6.27
Tata Medium Term Fund(G)-Direct Plan -11.74 -11.14 -9.78 -5.50 -1.32 2.82
Category: Benchmark
Crisil Composite Bond Fund Index 2.56 4.20 5.82 11.78 6.25 8.03
Crisil Liquid Fund Index 0.68 1.90 3.74 7.71 7.32 7.19
Crisil Short Term Bond Fund Index 1.34 2.66 4.90 9.46 6.92 7.63
Data as on June 07, 2019
Source: ACE MF

Corporate bond fund losing approximately 30% of its value is a dismaying sight.

Wondering how it happened?

No strict guidelines exist to restrict mutual funds from taking credit risk in non-credit risk fund categories. The fund managers can still go overboard on credit exposure to private entities and will now find it easy to use side pockets to their benefit. This might make it easy to conceal their reckless lending activities from the public eye.

It's an instance of fund houses relying excessively on credit ratings.

Is side-pocketing effective?

Side pocketing helps curb panic redemptions as the mutual fund carves out the troubled portion of the portfolio hoping to recover money someday. No redemption or switch facility is available for units held in the side pockets.

If the fund house is confident about recovering money from the debtor, creation of side pocket might help; otherwise, it will result to postponing today's loss to some future day.

Exiting at a Net Asset Value (NAV) that reflects the write off funds on account of delays/defaults results in booking of loss. As we have seen in the recent past, NAVs, depending on the funds' exposure, have taken a knock in the range of 10%-50%.

To handle redemptions, mutual fund houses often end up off-loading good quality papers since they are liquid and get stuck with illiquid and low-rated debt securities.

Does taxation make side-pocketing less attractive?

According to media reports, side pockets don't attract any capital gain tax or even gift tax at the time of creation. However, they are treated as the separate capital asset. Hence units held therein, if redeemed before the completion of three years, would attract a short term capital gains tax at the rate applicable to an assessee.

That said, one could book a loss (if any) on the units held in the main scheme since there's no change in the cost of acquisition of number of units purchased initially.

Mutual funds should offer clarity on the taxation aspect of side pockets while offering an exit window to their investors.

Side-pocketing can be a worrisome trend because...

Unfortunately, the current scenario suggests that mutual funds haven't learned anything from their past mistakes. Side pocketing can be a bad precedent.

The last time the question of side pocketing was in the limelight, mutual fund houses were chasing higher returns. Their exposure to "A" rated bonds had risen sharply and there was a gradual decline in their exposure to "AAA" bonds.

Now they seem to have taken the whole ecosystem for granted, which is even worse.

Although it's true that IL&FS enjoyed 'AAA' rating until recently and this was a comforting factor for many fund houses to invest in its subsidiaries, couldn't they have conducted intensive research independently?

When subsidiaries of IL&FS ventured into unchartered business verticals, their prospects suffered due to regulatory delays, and their balance sheets weren't strong enough to justify their borrowings. Yet the mutual fund house loaned them money.

The only plausible explanation for this could be the strong shareholding profile of IL&FS.

So were fund managers taking the promoters of IL&FS for granted?

The deeper you dig, more startling facts surface...

When there was ample liquidity in the market post demonetisation, many fund houses mopped up a large chunk of it through debt funds. In the quest for good returns, they invested aggressively in credit instruments issued by Non-Banking Financial Companies (NBFCs).

Hopefully, mutual funds will be more diligent with your money in future.

We, at PersonalFN, believe investors should carefully analyse available options on various quantitative and qualitative parameters before investing in mutual funds. Financial goals, time horizon, and risk appetite are the important factors you should consider before investing in mutual funds.

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