How lack of side-pocketing of stressed securities benefits speculators

Highlights:
- The failure of debt funds to create a segregated portfolio or side-pocket stressed securities benefits speculators at the cost of the original investors
- Without side-pockets, speculators can enter funds and share profit with original investors from recoveries
 -------------------------------------------------

Last week, India’s mutual fund industry witnessed an extraordinary U-turn. Sundaram Asset Management Co, which had announced the creation of segregated portfolios (through side-pocketing) in its schemes exposed to the securities of the beleaguered DHFL group of companies on August 16, reversed its decision five days later on August 21. Four schemes of Sundaram MF — Sundaram Low Duration, Sundaram Short Term Debt, Sundaram Short Term Credit Risk and Sundaram Debt Hybrid — were exposed to DHFL securities. On August 16, the asset management company (AMC) wrote off its entire exposure to the stressed securities.

The U-turn exposes a broader problem in the industry that has been hit hard by debt defaults. AMCs have shied from creating side-pockets and that gives a window to speculators to enter open-ended funds that have written off exposure to troubled debt and benefit from windfall gains when recoveries are made. These gains come at the cost of the original investors in the fund.

Collectively, mutual funds had an exposure of Rs 5,336 crore to DHFL on April 30, according to data from Value Research. Of this, around Rs 550 crore was in closed-end funds, which speculators can’t enter. Some open-ended funds have closed fresh inflows and, hence, speculators can’t enter them either. But many others have only hiked exit loads, which is not the perfect deterrent, and some other funds have done nothing at all.

The Sundaram MF story
DHFL defaulted on June 4, and Sundaram MF was supposed to create a side-pocket on the same day as the default, according to a plain reading of the Securities and Exchange Board of India’s (SEBI) rules. However, Sundaram MF first announced its intention to side-pocket on July 31 by amending its scheme information documents (SIDs). It then went ahead with specific side-pocketing proposals for its DHFL-hit schemes on August 16, which it subsequently withdrew on August 21.

Talking about the same-day rule, a person with knowledge of the matter said that a subsequent event of default cannot be sufficient condition to side-pocket. “For example, some AMCs did not hold the debt in default on June 4 but instead faced defaults on their paper subsequently. However, this does not make them eligible for side-pocketing on the dates on which they faced default on their paper. This inflexibility in SEBI’s circular has accentuated the problem faced by an industry that failed to react in time," the person said, requesting anonymity.

Meanwhile, Sundaram MF’s exposure of Rs 52.21 crore to DHFL may be small in absolute terms but is large as a percentage of assets and that has showed up in the returns of the affected schemes. Sundaram Low Duration, Sundaram Short Term Debt, Sundaram Short Term Credit Risk and Sundaram Debt Hybrid gave one-week returns of -4.08 percent,- 4.84 percent,-5.52 percent and -2.34 percent, respectively, as of August 21, according to data from Value Research.

Response to side-pocketing
SEBI came up with the side-pocketing solution in December 2018. It involves the creation of a separate portfolio in lieu of troubled debt. Only existing investors in the concerned scheme are allotted units in this segregated portfolio. When there is recovery in debt, the investors holding the side-pocketed units get their money.

It is unclear why mutual funds haven’t resorted to side-pocketing. An industry professional, who spoke on the condition of anonymity, said the same-day rule for side-pocketing leaves fund houses little time to deliberate the decision.

Two executives from two different fund houses, which have taken smaller hits or have not yet been affected, said on the condition of anonymity that there was no need for side-pocketing. One of them said one of the reasons why the fund houses were not side-pocketing was that changes in SIDs involve sending emails and letters to investors and giving them an exit load-free window. This may alarm investors, the person added.

Some AMCs such as Tata Mutual Fund have implemented side-pocketing, while others such as Motilal Oswal Ultra Short Term Fund and Edelweiss Corporate Bond Fund have stopped fresh inflows. Some others such as UTI Mutual Fund have chosen only to hike their exit loads. As the recovery process in DHFL lengthens, these exit loads will lose their effectiveness and speculators, with a little patience, can pocket windfall gains. Still others have chosen to do nothing, leaving the field open for opportunists.

“SEBI should make it compulsory for fund houses to amend SIDs and insert an enabling clause for side-pocketing. It does not mean the AMCs would be forced to carry out the actual procedure if an event of default happens, but it creates the necessary conditions for them to do so," said Suresh Sadagopan, founder, Ladder7 Financial Advisories.

What should you do?For mutual funds hit by DHFL, it may be too late to side-pocket under existing SEBI rules since the credit event has come and gone. Investors who exit the affected schemes give up any chance of recovery in the bad debt. They may also have to pay exit load and capital gains tax. Those who stay face the risk of their profit being shared with speculators and fresh investors — future recoveries go to the original investors and fresh investors, while the loss was only borne by the original investors.

Mrin Agarwal, founder director of Finsafe India Pvt, said, “The investor’s decision shouldn’t be about whether staying or leaving will affect chances of recovery of money in bad debt. Rather it should be about whether the investor is willing to stay with a scheme that has taken such high risks and may continue to sit on other risky papers.”

Each investor should weigh the cost and benefits of exit, taking into account the percentage exposure to bad debt in the scheme, the chance of recovery and tax or exit load payable. There is no fool proof solution.