SEBI, the mutual fund regulator, tightened its mechanisms, since the global financial crisis of 2008, to ensure fair treatment to all unitholders in case of a credit event through various orders like modification of its valuation guidelines and restrictions on redemption in mutual funds (Redemption Gate). The recent defaults on debt obligations by a few entities particularly in September 2018 and subsequent volatility in the debt and money market instruments issued by NBFCs and HFCs resulted in redemption pressures in debt mutual fund schemes, more specifically in liquid schemes. An analysis of Asset under Management (AUM) of all debt-oriented schemes indicates that their AUM declined from ₹ 12.13 Cr to ₹9.9 Cr over a period of two months with effect from 31 Aug 2018 i.e. a decline of around 18%. The Indian bond market has relatively lesser depth and width than developed markets that permit side pockets of non-retail funds. More so, Indian mutual funds that invest in debt and money market instruments face liquidity constraints in case of credit events, since trading in those securities freezes, as seen recently. With this as the backdrop, the SEBI permitted side pocketing of debt mutual funds and money market instruments in all mutual fund schemes, at the discretion of the fund house, on the day of the downgrade of a debt instrument to below investment grade or on the day of each subsequent downgrade from below investment grade.
Side Pocketing is a mechanism to separate distressed, illiquid, and hard-to-value assets from other more liquid assets in a mutual fund portfolio. This prevents the distressed assets from damaging the returns generated by more liquid and better-performing assets. To side pocket, the fund house generally creates a separate portfolio of distressed, illiquid, and hard-to-value assets and declares separate NAVs for this portfolio. Each investor is allocated his/her pro-rata share of units in the side pocketed portfolio. The rules do not permit redemption or subscription in the bad asset portfolio. When the bad asset recovers, the side pocketed portfolio also recovers and the fund house distributes the profit amongst the investors on a pro-rata basis.
The distinct advantage of side pocketing is that it offers investors the benefit of selling liquid investment and staying invested in risky funds until they generate profitable returns. It also prevents a new investor from taking undue benefit from the investments of a previous investor. Further, it mitigates the risk accompanying the credit-risk investments. One big disadvantage is that the fund house may find it difficult to determine the NAV of the illiquid or defaulted assets since their valuation remains contentious.