Side pocketing: Here are pros and cons for retail investors

The Securities and Exchange Board of India (Sebi) permitted the mutual funds who have an exposure to troubled assets (such as IL&FS) and certain funds giving negative returns, to use side- pocketing tool.

Side pocketing: Here are pros and cons for retail investors

The Securities and Exchange Board of India (Sebi) permitted the mutual funds who have an exposure to troubled assets (such as IL&FS) and certain funds giving negative returns, to use side- pocketing tool. Let us understand the nuances of side-pocketing and check whether is it advantageous to the investor community.

Concept and characteristics
It is a mechanism to segregate in a given portfolio, illiquid and/ or hard-to-value assets from other liquid and valuable investments. This mechanism, therefore, segregates the affected portion of the portfolio in two asset pools so that the fund can continue to operate in a normal manner. Accordingly, the mutual fund calculates two net asset value (NAV) for the same scheme by differentiating good and liquid assets from troubled and illiquid assets.

Through the use of side-pockets, funds intend to protect the investors’ interests by avoiding the need to realise or liquidate the illiquid investments or positions, where there is greater inherent subjectivity in the valuation of such assets prior to their realisation or other key event.

Advantages and limitations
By means of side-pocketing, mutual funds ensure that all existing investors are equally exposed to the fund’s entire portfolio and treated in an equitable and equal manner with reference to redemption and subscription requests. Further, side-pocketing usually avoids additional valuation conflicts by not assessing management fees until a particular investment in a side pocket is realised. The complex issue concerning side pocketing is the valuation of the assets. One valuation may not be sufficient to correctly value the illiquid assets. From the risk management point of view, certain portfolio components (the illiquid assets put in the side pockets) are ignored and hence diversification numbers may not capture the full picture of the fund’s portfolio.

Another challenge may be the relative inexperience of the fund managers in holding illiquid assets and as regards the creation of value over the medium to long term. Possible abuse of side-pocketing by the manager to move poorly performing investments into side-pockets in order not to jeopardise his management fees may be possible. Sometimes side-pockets may raise disclosure and investor distrust issues. Further, transparency and disclosure obligations to the investors may act to compromise the fund’s competitiveness.

When to use side-pocketing?
Side-pocketing is recommended in two circumstances by investment managers. The necessity at a certain time during the life of the fund to segregate certain assets of the fund from the other assets in order to avoid contamination by distressed, illiquid or hard-to-value assets to the other assets of the fund and thus ensure the survival of the fund as a whole and/or to continue the application of its redemption policies, especially in the case of distressed assets.

This is the conservative use of side-pockets. On the other hand, is the desire or the need to segregate certain classes of assets from the general portfolio in order to be able to pursue alternative and illiquid investment strategies in combination with liquid investment strategies. This is the dynamic use of side pockets on the other side. The second option, the dynamic use of side pockets, is generally reserved for non-retail funds while the first option, the conservative one, may under certain circumstances be worth for retail funds.
Alternative ways

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There is a variety of other protective strategies available to funds holding illiquid assets and facing redemption requests. Some of the most common special redemption clauses are establishment of redemption gates, redemption in kind of the problematic assets, lock-up period, suspension of the NAV and finally liquidation of the fund.

Will it help investors?
Side-pockets were mainly used in western markets, wherein the markets are well developed and regulated, by hedge funds desiring to manage hybrid portfolios of both liquid, marketable assets and more illiquid, hard-to-value assets such as real estate, private equity and distressed securities.

Side-pocketing in India may be allowed only in relevant cases with the fund trustee’s approval. At the same time, side-pocketing could be a disruptive tool which restricts access to investor capital and recommends greater regulation to avoid abuse.It is like a double-edged sword, with the potential to protect as well as harm the investors, especially retail investors.

(The writer is a professor of finance and accounting, IIM Tiruchirappalli)

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