Franklin Templeton India Crisis | Opinion | Mutual funds side-pocketing distressed assets is one step short of pickpocketing investors

The Securities and Exchange Board of India (SEBI) is considering allowing mutual funds to segregate distressed debt securities in a scheme, a practice called side-pocketing. Such a move would be nothing short of outrageous and presents a clear moral hazard.

The default at some IL&FS units which has hit non-banking finance companies and mutual funds alike seems to have prompted this move. This is not the first time that the mutual fund industry is asking permission for side-pocketing. JP Morgan had done this — in the absence of clear rules —when Amtek Auto had defaulted.

Side-pocketing allows a mutual fund to carve out the distressed and illiquid securities in a scheme into a separate pile. The scheme will then be carrying two sets of papers — one with highly rated instruments and the other, junk, — each of which will have separate net asset values (NAV).

Any redemptions and sales of fresh units of the mutual fund will happen from the ‘good’ asset pile. When, or if, the distressed assets are resolved, gains from them will accrue only to those investors that were invested in the scheme at the time of default.

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The logic behind it is to prevent redemption pressure on the fund due to the default in an investing company. Typically, when there is a default, investors rush to redeem money from a scheme. The mutual fund can meet these redemptions only by selling the good paper and thus, the composition of the scheme will increasingly tilt towards bad paper. This will penalise those investors who choose to remain invested.

The assumption that side-pocketing will prevent redemption is wishful thinking. The NAV of a fund will anyway take a hit because the value of the securities that saw a default has to be marked down. That very fact that some instruments have seen default might cause investors to redeem their money. Side-pocketing will simply be construed as a desperate attempt to prop up the NAV.

In any case, mutual funds cannot simply hide behind rating agency recommendations. The first default in the case of IL&FS happened in June, yet most funds were holding these securities in September 2018 despite a series of defaults. Had not the government stepped in to bail out the infrastructure finance giant, would not the entire mutual fund industry been in a fix?

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Side pocketing will give fund house and the fund managers a longer rope in selecting the paper. They could pick riskier paper and simply set aside any wrong investments and move on to pick the next one till it blows upon them. Fund managers can potentially abuse this system by claiming management fees on the good assets, and to hide their poor performance.

There will be no lessons learned as has been seen in the case of IL&FS default which took place within years of the Amtek Auto default.

Pampering fund managers is only going to destroy the market. Shrewd investors would prefer direct investment rather than routing them through the mutual fund's route. Fund managers in equities will be waiting for the day when SEBI allows a similar side-pocketing for equity investments. The very thought of such an law being introduced for equities sounds ridiculous.

The rules of investment should be the same for all asset class. One set of fund managers cannot be allowed to get away with poor analysis and others pulled up for it. A better idea would be to create a junk bond market for such investments.

(This story was originally published on November 28, 2018, and has been updated in the wake of Franklin India Templeton crisis)