The Securities and Exchange Board of India (Sebi) has allowed debt mutual funds to have a “side pocket” that will allow fund managers to segregate their holdings in stressed assets. Mint gives the low-down on what this means for investors and fund houses.

What is a mutual fund side pocketing?

A mutual fund side pocketing helps separate risky assets from other investments and cash holdings. It ensures that the money invested in a mutual fund liquid scheme, which is linked to stressed assets, gets locked, until the fund recovers the money from the company. Investors can redeem the rest of their money. A “side pocket” is typically used by hedge fund managers to differentiate illiquid assets from more liquid investments. Sebi is making it a norm for mutual funds in the wake of serial defaults at Infrastructure Leasing and Financial Services (IL&FS) and its impact on liquid funds that held IL&FS securities worth ₹2,800 crore.

How will mutual fund side pocketing the move help investors?

Sebi chairman Ajay Tyagi said the move would protect retail investors. Once the affected papers—the ones facing a default—are segregated from the rest of the holdings, there will be two sets of net asset values for the mutual fund scheme. Once segregated, investments in the toxic asset will be closed for subscription, while investors can continue to subscribe to or redeem part of their investment in healthy assets. Considering that in a crisis situation, institutional investors have the first right to redemptions and retail investors are stuck with toxic assets, the segregation will help avoid that.

But is it all good for the investor?

No. There may be a flip side. Fund managers may end up taking risky bets or credit risks to boost returns. Some global jurisdictions consider such an arrangement a moral hazard.

How will it help fund houses?

Typically, when a paper defaults, redemption requests pour in. As a result, toxic assets form a larger part of the scheme. Ring-fencing risky assets will help fund houses manage redemption pressures better, as other holdings will not be impacted. They will be able to focus on recovering the money from the issuer, who has defaulted on payments, without the pressure of allaying investors’ concerns. The move would thus help in fund management, said Sumit Agrawal, founder of RegStreet Law Advisors and a former Sebi official.

What will Sebi do to ensure that the facility is not misused?

Sebi is introducing safeguards to ensure that the provision is not misused and fund managers do not become reckless. It is yet to notify them, but people familiar with the matter say a fund manager may need the clearance of the board of trustees before investing in such risky assets; the performance of the scheme may also be monitored by the board. Fund managers will be able to use the facility only in select credit events such as in the case of a default in interest payments by the issuer.