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Side Pocketing: Does this matter to you as a debt fund investor?

A ‘side pocket’ option allows a mutual fund house to separate bad assets or risky ones from other liquid investments in a debt portfolio which could get impacted by the credit profile of underlying instruments.

The term side pocketing is relevant to you if you are a debt fund investor or planning to invest in one. 

Recently some mutual funds created a side pocket for some of its debt mutual funds which had invested in debt issued by Idea-Vodafone. This move came after CRISIL downgraded debt securities issued by Idea-Vodafone’s below investment grade.

Many debt fund investors are naturally concerned after this and have quite a few questions. Let’s try to look at these and arrive at no-nonsense answers that can help you as an investor understand and do the smart thing.

What is side pocketing?

A ‘side pocket’ option allows a mutual fund house to separate bad assets or risky ones from other liquid investments in a debt portfolio which could get impacted by the credit profile of underlying instruments. 

Why do debt fund companies do this?

A segregated portfolio ensures that investors who wish to exit the fund can withdraw at least the healthy portion of the fund i.e the main fund without booking any loss while they continue to hold units in the segregated portfolio.

What happens when side pocketing is created?

Your original mutual fund is divided into two: 

Main portfolio

Segregated portfolio (with underlying assets where the default has occurred)

The main fund continues to operate as normal. The segregated portfolio remains locked for redemption until the default is resolved and money recovered in full or part.

When a debt fund realises that the debt securities it had invested in are likely to be defaulted on, often the prudent move is to write off these securities. A side pocket allows them to put these securities in a separate portfolio and in the event the securities are honoured at some point of time, then these investments can yield what they were supposed to.

Is it a good thing?

When a debt fund realises that the debt securities it had invested in are likely to be defaulted on, often the prudent move is to write off these securities. A side pocket allows them to put these securities in a separate portfolio and in the event the securities are honoured at some point of time, then these investments can yield what they were supposed to.

Such securities tend to be a small part of the fund and fund managers normally account for such possibilities which is why good debt funds have a diversified portfolio of debt securities.

The main thing is that your new investments in the debt fund won’t be exposed to the side pocketed securities. 

What do I experience as an investor if it happens to a debt fund I may be invested in?

While many investors see a significant (or insignificant, depending on how much of the affected security is held by the debt fund) drop in NAV values because of these kinds of write-downs, these have tended to be short term so far. 

But I thought debt funds were supposed to be safe?

Most liquid and ultra-short term debt funds tend to be quite stable despite such instances as they invest in multiple debt securities including those issued by the government and RBI. For example in the current series of events that affected Franklin Templeton and anyone else who had invested in Idea-Vodafone debt, liquid funds continue to remain stable and largely unaffected due to the nature of their underlying investments.

The answer for most investors is to invest in a portfolio of liquid and short term debt funds which hold multiple debt securities and are not over-exposed to any particular security. This is why choosing the right kind of, and the right, debt fund can be so important. This is what we at Scripbox also do.

But aren’t regulators like SEBI supposed to prevent such things?

SEBI had, in fact, come up with a recent guideline that allowed AMCs (Asset Management Companies) to create side pockets and also asked AMCs to come up with a proper structure to do so. This is allowed only in the case of major credit crisis events and needs AMCs to follow a series of steps including creating a provision for creating such side pockets.

This is why if you are a debt fund investor you might have received emails from the AMC informing you of the approval of such provisions from the board of directors and the trustee company, based on the SEBI guideline. Debt funds in many cases are creating such provisions even if they don’t have any affected debt securities thanks to this guideline. 

Be rest assured that these matters are under close watch and the regulator is on your side.

As a Scripbox Short Term Money Investor am I going to be impacted?

There is no impact on your investments and hence there is no action required from you. We are closely monitoring all the funds in the Scripbox portfolio and we will let you know if any action is required.

Our algorithm automatically prioritises the credit quality of the underlying investments made by a debt fund to ensure the least possible default risk given the information that is available at the point of selection. We also monitor this continuously and inform investors like you, in case we recommend an action.

Do these events make debt funds a bad investment?

There is no reason to believe that such events make debt funds, especially low duration and liquid ones, bad investment instruments as a whole. 

The tax efficiency, liquidity, general stability of returns, and diversification of securities benefits that good quality debt funds bring to the table make them some of the best investment approaches for short term investing needs.

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