Side Pocketing In Indian Funds: Have We Finally Seen A Beginning?
What the first formal use of side pocketing provisions introduced by SEBI tells us, writes Vijai Mantri.
Tata Asset Management Ltd. said it will introduce side pockets in three debt schemes hit by the Dewan Housing Finance Corporation Ltd. debt crisis—Tata Corporate Bond Fund, Tata Medium Term Fund and Tata Treasury Advantage Fund. It also suspended fresh inflows into these schemes as well as redemptions. This is India’s first formal use of the side pocketing provisions introduced by Securities and Exchange Board of India in December 2018.
The three schemes saw overnight drops in net asset value of approximately 30 percent, 12 percent and 4 percent, respectively, after DHFL failed to make interest payments on some of its debt, causing independent valuation agencies to mark down the debt held by mutual funds. Investors will receive units in the segregated portfolio, which will be held separately. No further inflows are allowed into the side-pocketed component of the fund. And investors will be allowed to redeem these units when money is recovered from the bad debt in question. Taking a different approach, UTI Asset Management Company Ltd. chose to increase DHFL's markdown from 75 percent to 100 percent on debt securities that have exposure to the debt papers of DHFL, instead of side pocketing.
Why Different Treatments To The Same Event?
Tata Corporate Bond fund had smaller assets under management, and the exposure to DHFL paper was nearly 25 percent of their total AUM. When a fund decides to side pocket, the fund needs to change the offer document, and this results in changes to fundamental attributes of the scheme. It triggers a 30-day exit window, without any exit loads. Tata AMC may have felt that because of the smaller AUM and because a large hit had already happened, major redemptions wouldn't take place.
Contrast that with the schemes of UTI AMC, which have chosen to write down the whole exposure of DHFL. These have larger AUMs in each of the schemes, and didn't have a very large exposure to DHFL paper as a percentage of their overall AUM. Side pocketing would have exposed the entire AUM to an exit-load free redemption. As I will explain, due to lower liquidity in the debt markets, selling debt paper in the case of even mid-sized redemptions could lead to significant markdown in value, which may not be in the interest of the unit holders of the fund. In the current scenario, it would have been catastrophic for the fund.
Side Pocketing—The Pros
The debt AUM of the mutual fund industry declined from Rs 12 lakh crore as of Aug. 31, 2018, to less than Rs 10 lakh crore by October-end—a decline of over 18 percent in two months. In case of liquid and money market schemes, the AUM had declined by around 25 percent during the same period. This was despite the fact that the total exposure of mutual fund schemes to the IL&FS group was approximately 0.24 percent of the debt AUM of the mutual fund industry.
Inference—a credit event in even one issuer/group could lead to significant liquidity risk for the entire industry, which can lead to further market volatility. Accordingly, the need arose for a mechanism to deal with situations in mutual fund schemes due to credit event on a debt security in its portfolio. Thus emerged the concept of ‘side pocketing’ in the Indian markets. And as and when more funds incorporate the option in their offer documents, this will gain prominence and acceptance.
The Disadvantages
The provisions for side pocketing may encourage fund managers (there is thought of linking compensation to fund performance) to take undue credit risk in the scheme portfolio for higher compensation. Also, since the debt market isn't very liquid, discovery for true value of the security can be a challenge. Investors will often find it difficult to track two sets net asset values (NAVs). And if the guidelines for side pocketing get diluted in the future, fund houses could also misuse side pockets to hide poorly-performing assets or poor liquidity management by its fund managers.
Keep in mind, the option of side pocketing is as per the discretion of the asset management company. AMCs may differ on the merits and timing of side pocketing, which may create confusion in the mind of investors. And side pocketing is only allowed when ratings for a security get downgraded "below investment grade". What about instances where a security gets multiple downgrades, but still remains investment grade? These questions and many more will need answering as we explore the uncharted waters of side pocketing in the future.
Having said all of this, I believe that once the dust settles over the credit squeeze issue, more funds will incorporate the option of side-pocketing in their offer documents itself, which will enable the funds to side pocket without giving an exit load-free exit to unit holders. Maybe the future is when the pros and cons of side pocketing will come to the fore.
Vijai Mantri is Chief Investment Strategist, Co-Founder & Mentor, JRL Money. The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.