Sebi rejects mutual fund industry’s side pocket proposal

Mumbai: The capital markets regulator has rejected a mutual fund industry proposal to allow them to isolate risky assets from the rest of their holdings and cap redemption, saying that it will encourage fund managers to take unnecessary risks, three people directly familiar with the developments said.

The Association of Mutual Funds of India (Amfi) in March approached the Securities and Exchange Board of India (Sebi) to set rules for the creation of a so-called side pocket when a specific investment faces a credit risk as a way to insulate the broader portfolio from redemption pressure.

JP Morgan Asset Management (India) Pvt. Ltd pursued this approach last year even though there were no clear regulations in place. The asset manager restricted redemptions as investors demanded their money back after the net asset values of two of its schemes plunged following the downgrade of the credit rating of Amtek Auto Ltd’s bonds.

JP Morgan had a Rs.193 crore exposure to Amtek Auto.

This prompted the mutual fund lobby body to approach the regulator for a set of regulations that would help standardize the practice.

The regulator, however, is not in favour of establishing it as the norm.

“Sebi is of the view that mandating the creation of a side pocket, to minimize the redemption pressure on the entire fund arising from their exposure to any particular company, could lead to some fund managers taking unnecessary risks,” said the chief executive officer of a large fund house, requesting anonymity.

An email to Sebi on Thursday remained unanswered.

Amfi, which represents the Rs.13 trillion asset management industry, had discussed the creation of side pockets at its board meeting in February and sent its recommendations to Sebi saying that side-pocketing is a pragmatic and practical way to minimize stress.

A side pocket is used by fund managers to separate stressed or risky assets from other investments and cash holdings. Fund houses create side pockets to ensure that while a proportion of investor money (in the scheme) linked to stressed assets gets locked until the fund recovers dues from a stressed company, investors are free to redeem the rest of their money if they choose to.

A top executive at another large asset management company confirmed that Sebi has informally communicated its displeasure and is not in favour of side-pocketing becoming a common practice.

“The moment you create a safety net, you encourage risk-tasking. It’s common for regulators to argue that they don’t want to create conditions where market participants can take higher risk,” he said, requesting anonymity as communications with the regulator are confidential. “Secondly, there could be worries about asymmetry of information in such a situation. Depending on how and when the news (of a fund house creating a side pocket) hits the market, it could result in some investors exiting earlier than the others,” he added.

The regulator’s unwillingness to make segregation of assets a norm has fund houses wondering whether they can go ahead and create side pockets in the future without Sebi approval.

“To be honest, it’s best to have clarity. It’s very stressful for everybody concerned if the fund house does it entirely on its own, at its own discretion, without prior approval of the regulator. The industry must ensure that there is no regulatory breach later on,” said the second official cited above.

A third person, the chief executive of a mid-sized fund house, said that in the absence of Sebi regulations, funds could run the risk of regulatory action if they create a side pocket.

“In the absence of any Sebi rule, the trustee board would have to take a call that whatever they do is beneficial to the investor. I think they can go ahead if the trustees approve,” he said. “However,such fund houses may also run the risk of Sebi questioning them later on. It could possibly become a mess.”

Kaustubh Belapurkar, director of fund research at Morningstar Investment Adviser India Pvt. Ltd, a mutual fund tracking and research firm, believes that segregation of assets would have been a prudent practice.

“Sebi’s concern is fair, but we assume that fund managers are aware of their fiduciary responsibility, that they are doing the best research possible in selecting the right security to invest in. But just in case there is an untoward incident, creating a side pocket, probably, is the best way to protect investors’ interest,” he said.

India’s largest rating company Crisil Ltd downgraded debt worth a record Rs.3.8 trillion in the year ended 31 March. “Debt of firms downgraded by Crisil in fiscal 2016 has risen to an all-time high of Rs.3.8 trillion, underscoring that credit quality pressures continue to mount for India Inc,” the rating agency said in a report released on 4 April.

This deteriorating credit quality has hurt certain fund houses. The latest to be hit due to a ratings downgrade was Franklin Templeton Asset Management (India) Pvt. Ltd.

It sold its entire holding of Jindal Steel and Power Ltd debt securities at a loss after the company had its ratings downgraded by Crisil.