Mutual Fund Sahi Hoga!

The Mutual fund industry has been going through an intractable phase, especially the debt market, starting with the IL&FS fiasco and then proliferating to entities like DHFL, Essel Group, ADAG Group among others. The slogan “Mutual Funds Sahi hai” has gone for a toss at the moment.
MF Sahi hai
To protect the interest of investors (retail in particular), the SEBI had come out with an interesting concept of Side Pocketing.
Side Pocketing in mutual funds helps separate risky assets from other investments and cash holdings. It ensures that money invested in any mutual fund schemes, which is linked to stressed assets, gets locked, until the fund recovers the money from the company.
SIde pocketing
How will this move benefit the retail investors?
When a certain portion of investment faces a default, that portion gets segregated from the rest of the holdings. This leads to creation of 2 sets of Net Asset Values (NAV) for the scheme. The portion of investment in toxic asset gets closed for subscription, while the investors can continue to subscribe to or redeem part of their investment in healthy assets. Let us understand this with an example.
Suppose there is a debt fund with a corpus of INR 5,000 crore and has 10% exposure to a company which has defaulted. The remaining INR 4500 crore are held in financially sound companies. Due to this default, many large investors would try to redeem shares from the scheme to avoid any further loss. The fixed income manager, to honour the obligation would be forced to sell good papers, while the bad paper remains in the scheme because of its illiquid nature. In such a situation, the % holding of bad paper in the total portfolio rises, often leading to a sharp decline in NAV. Such a scenario could be very well mitigated with the help of Side Pocketing and would also keep the interest of the investors intact.
Although this doesn’t solve the entire problem of bad investments yet it will help to avoid the domino effect in the capital market.

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