Side pocketing mutual fund units

I have a piece today in today's Economic Times on side-pocketing in mutual funds linked here. Where a mutual fund holding defaulted debt paper, is able to create two units one 'good' one 'bad' where one existed. The enablement not only creates new liquidity for investors, but also closes classes of investors. In other words, it minimises windfall to new investors and losses to existing investors. The unedited piece is copied below:

"If you are an investor, why should you care about a sartorial concept of storage and where it is located? In fact you should if you are a mutual fund investor. In plain English, side pocketing is the splitting of a mutual fund unit into a bad unit and a good unit when part of the investment of a mutual fund goes sour. More specifically, when your investment in a mutual fund gets invested in debt securities of a corporate, and that corporate defaults to the fund, you are left holding a unit with, say a clean 95% and a dubious 5%. While the 95% is almost certain to give you back your money, the other may be say the IL&FS group's commercial paper.

Most funds would write down the value of the 5% either partially or fully. Seen differently, there is, and rightly so, a discretion as to how much to mark down the 5% portfolio. Fund manager A may believe that a commercial paper may after a year of litigation under the new insolvency regime, return 50% of the paper’s value, while fund manager B may believe the number to be 30%. After a year, once the insolvency process is over, or other compromise is struck, the number recovered will be anywhere from 0% to 100%. If the amount recovered is 40% then the manager who marked it down 30% was too conservative and the one who marked it down 50% was not sufficiently cautious. But that is wisdom gained in hindsight with the omniscience of god. Clearly, any call taken by a fund manager (not living as an Oracle on Mount Delphi) will be wrong in hindsight.

These calculations are important to understand the issue because if the side pocketing is not done, the asset value of the mutual fund unit will be between Rs. 95 and 100, where the value of a unit is say Rs. 100. The price will however be what the fund manager marks it down decides. So if the fund marks down the asset value by 50%, the net asset value per unit will be Rs. 97.5. People will then buy and sell the unit at Rs. 97.5. Theoretically, thousands of investors may come into the fund after the default situation had arisen. After a year of resolution, the actual value of the mutual fund unit recovered is say Rs. 99. The class of investors who sold when the price was Rs. 97.5 will thus have lost money if the value is discovered at Rs. 99, because had they held on to it, it would have given them an extra Re. 1.50. Conversely, any new investor who bought then would get an unfair windfall of Re. 1.50. The situation would reverse if the price was Rs. 96 instead of Rs. 99.

Side-pocketing achieves three benefits. First, it excises the frost-bitten limb from the body of the mutual fund unit. So a person has a choice or an option of selling the good unit at an accurate price while keeping or selling the bad unit. If the person chose to sell both the units immediately, he would be in no worse a position as a person who sold the undivided unit. However that would be one option for the investor who benefits from the side pocket. The investor has three other choices besides selling both units. One, retain both units till maturity. Two, sell the good unit and retain the bad one. Three, sell the bad unit and retain the good one. Clearly a person with 4 choices is better than a person with one choice, specially when those 4 choices include that one choice.

The second benefit of side pocketing is that it freezes the class of investors, so that new investors who did not face the loss and potential recovery do not share in the windfall if there is greater than expected recovery. Clearly, this is not a given and is dependent upon the level of mark-down effected by the fund manager, but it helps in reducing the chances of windfall to a person who didn’t suffer the downside.
The third benefit is systemic. In a situation like the current one where contagion has spread across commercial paper issued by NBFCs, any panic in the liquid funds because investors shun mutual funds which have an exposure to NBFC paper, even if good quality, would freeze credit markets and cause a serious run for withdrawal from such funds. Selling securities in such situations is often met with a frozen market where underlying securities cannot be sold at any price. A side pocket would reduce a run on the system, though not by any means eliminate the problem.

The only downside of a side pocket in theory is that it may encourage fund managers to buy riskier securities because they can always chop off the bad part when things get tough. This is an unlikely outcome, because the stigma attached to holding defaulted paper is huge and funds which held IL&FS paper recently were penalised through large redemptions even though they bought triple A rated paper, as it was before the default. It must be said that this is an experiment by SEBI, as few countries have enabled side pocketing outside of the world of hedge funds. But it is a good experiment with little expected downside. Indian securities market regulations have been pioneers in many global best practices and there is no reason we should always copy other models, rather than start regulatory trends."