What is the side pocketing rule?
Simply put, side pocketing is a framework that allows mutual funds to segregate the bad assets in a separate portfolio within their debt schemes. The Securities and Exchange Board of India (SEBI) introduced the framework in December — primarily triggered by the IL&FS fiasco — after it emerged that many fund houses have huge exposure to the beleaguered entity and could potentially take a huge hit on their net asset value thereby affecting investor returns.
How does it work?
The capital markets regulator has laid down that such a portfolio can be created only if there is a credit event at the issuer level in the form of downgrade of a debt or money market instrument to ‘below investment grade’ or subsequent downgrades from such levels.
In other words, if a debt instrument is downgraded to default rating by credit rating agencies, then the fund house has the option to create a side pocket so that good assets can be ring-fenced.
How does it benefit investors?
Side pocketing segregates the bad assets from the good ones. All existing investors in the scheme are allotted equal number of units in the segregated portfolio as held in the main portfolio and no redemption or subscription is allowed in the segregated portfolio.
Thereafter, the units have to be listed on a stock exchange within 10 days to facilitate exit of the unit holders. Effectively, this makes the price discovery of the bad assets a transparent procedure with investors having the freedom of either selling it at prevailing price or holding it if they expect the value to recover in future.
Can the side pocket rule be misused?
When side pocketing was introduced, a section of market participants felt that it could be misused by fund houses to hide their bad investment decisions. SEBI, however, has put in place checks and balances to minimise any such misuse. The regulator has said that trustees of all fund houses will have to put in place a framework that would negatively impact the performance incentives of fund managers, chief investment officers (CIOs), etc. involved in the investment process of securities under the segregated portfolio. So, fund managers know that any creation of such side pocket in the future would also affect their own appraisals and incentives. Further, SEBI has also said that side pocket should not be looked upon as a sign of encouraging undue credit risks as any misuse of the option would be considered serious and stringent action can be taken.