How to side pocket your MF losses?

When Tata Mutual Fund (MF) segregated the portfolio of securities of crisis-hit mortgage lender DHFL held by its debt schemes in mid-June, the term 'side pocketing' made its entry into the Indian investment lexicon. Tata MF has become the first fund house in the country to do 'side pocketing' for its schemes.

Though side pocketing is in vogue in several developed economies, markets regulator Sebi allowed it in debt schemes of MFs only in January this year. To put it simply, side pocketing removes the bad apples from the good ones. The side pocket is generally formed by creation of a separate portfolio of distressed, illiquid and hard-to-value assets. Each investor is allocated his/her pro-rata interest in the side pocketed portfolio.

In the absence of side pocketing, in case of credit events, the existing investors potentially lose all value. With side pockets the investors, who take the hit when the credit event happens, get the full upside of a future recovery. When recovery is made in the side pocketed portfolio, the same is distributed among investors on a pro-rata basis.

What a side pocket means for an investor in debt MF schemes?

You cannot redeem (exit) your units in a side pocketed portfolio straightaway. The fund house would transfer the money to the investor in the segregated portfolio of the troubled investment (for example DHFL) when the debt security matures.

You can also get money if the fund house is able to sell the troubled securities after an upgrade from credit ratings agencies. Typically, an upgrade would result in an improvement in liquidity for the troubled investment offering a window of opportunity to exit.

Does it help investors?

Personal finance experts and advisors say it is useful for investors. "Side pocketing is actually good for investors. In the absence of a side pocket, there would be huge redemption pressure. The fund house would have to sell good quality securities to meet redemption requirements," says Suresh Sadagopan, founder of Mumbai-based Ladder7 Financial Advisories.

"Side pocketing is the best possible solution in schemes stuck with bad quality paper," says Amit Trivedi, a Mumbai-based author and trainer on personal finance. "Illiquid securities are quarantined in a side pocket. Whenever the company in trouble pays back or its securities are upgraded, money returns to investors," he says.

What would your portfolio look like after the segregation?

The number of MF units in both the side pocketed and the regular portfolios would be shown as the same. However, the net asset value (NAV) of the portfolios would be different.

In the case of Tata Treasury Advantage Fund, one of the schemes that has taken a hit, the mark-down on the side-pocketed portfolio with securities of DHFL was a whopping 74%. But that constituted less than 5% of the total portfolio before segregation.

The asset management company (AMC) will send an e-mail and SMS to all unitholders of the concerned scheme on the day of creation of side pocket. A revised statement of holding indicating the units held by the unitholder in the side pocket along with the applicable NAV of the main portfolio will be communicated to the unitholders within five working days of creation of the side pocket.

Side pocketing of debt and money market instruments is permitted on the day of 'downgrade' of a debt instrument to 'below investment grade' or on the day of each subsequent downgrade from 'below investment grade'. In case of difference in rating by multiple agencies, the conservative assessment may be considered.

If a MF decides to side pocket security, approval of trustees is mandatory. For this purpose, trustees' approval would mean that at least a majority of the trustees agree to the proposal of creating side-pocket. Till the time the decision of trustees is received, subscription and redemption in the scheme is suspended.

No investment and advisory fees can be charged by the AMC (asset management company) on the side pocketed portfolio. However, TER or total expenses ratio (excluding the investment and advisory fees) can be charged on the side pocketed portfolio but only upon recovery, on a pro-rata basis i.e. on the recovered amount.

The TER (excluding the investment and advisory fees) charged shall not exceed the simple average of such expenses charged on daily basis on the non-side pocketed portfolio (in percentage terms) during the period for which side-pocket was created.

The costs related to the recovery of the assets side pocketed may be charged to the side pocketed portfolio upon recovery, within the maximum TER limit. The recovery cost in excess of the TER limit shall be borne by the AMC.