In the aftermath of the crisis faced by debt funds holding bonds and CP of IL&FS and DHFL, the regulator decided to permit the side pocketing of debt funds. Here, the toxic assets in the fund will be hived off into a separate side pocket fund and only the good assets will remain in the principal fund.

How Side Pocketing works?

In terms of protecting the interest of investors, side pocketing offers the best option for mutual funds. In this case, when a debt fund portfolio is hit by toxic holdings in the bonds of IL&FS and DHFL, the fund has the option to separate the specific bonds into a side pocket portfolio. The side pocket will not permit any inflows or even redemptions so that distress traders do not make a short term profit at the cost of genuine long term investors. Under the side-pocket arrangement, your holdings in the fund remain the same. Instead, what the fund does is to transfer all toxic assets into a separate portfolio. The core portfolio without the toxic assets continues to permit free inflows and redemptions. Of course, the write off will still be taken but the side pocket ensures that short term traders do not make profits in distress at the expense of genuine investors who exited the fund. Funds normally write off 75% in case of distressed assets and any recovery from these toxic assets are directly credited into the side pocket account and paid back to the investor.

How is side pocketing working?

Unfortunately, a full 6 months after side pocketing was allowed, there is limited interest among funds. Tata AMC is the only MF to have side pocketed its toxic holdings. Most MFs prefer to either freeze fresh inflows or impose heavy exit loads on the fund to impose a cost on fund traders. Side pocket as a strategy is globally considered one of the best ways to protect the interests of the small investors in a mutual fund. Let us look at some reasons why the concept of side pocketing has not really taken off among Indian mutual funds?

Why it is a slow starter?

There are several reasons why the side pocketing has been a slow starter among funds. Firstly, a side pocket is a tacit admission that the fund has parts of the portfolio that are extremely stressed. That could have an impact on the performance of other debt paper too. Secondly, there are regulatory issues pertaining to side pocketing. A side pocket will be treated as a change in fund strategy and hence it will have to go through the regular scrutiny as well as approval of board of trustees. One way would be allow this clause to be part of the offer document. Lastly, tax aspects are not too clear. Whether it will be transfer and will it attract capital gains and what is the buying price; are all still unclear. SEBI and CBDT must give clarity at the earliest! ©