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February 19, 2019

Funds ride a roller-coaster year, end up with a side pocket

Record high assets of Rs 25 lakh crore at stake, swinging equity and debt markets, and the contagion of a major downgrade and default debacle, are sufficient reasons for industry regulators to swing into action. For that’s precisely what marks 2018, a year that ended in the red for most equity funds, and set the cat among some stoic investors because of the debt crisis in the latter-half and major measures introduced by the Securities Exchange Board of India (SEBI).


To recap, the credit and liquidity crisis in the debt markets was triggered by the downgrade in September 2018 of a large financial sector borrower, leading to a liquidity crisis among non-banking and housing finance companies. Mutual funds, being major investors in non-banking financial companies (NBFC) papers (up to 40% of the supply as of March 20181), were most severely hit. In response to the crisis, a major step, side-pocketing or segregated portfolios for debt and money market instruments in mutual funds has been introduced by SEBI.


This would allow fund managers to separate their holdings in stressed assets. For the investor, that would imply less volatility in the invested scheme. It would also help him/her recover the money from the issuer, rather than wait for the market to recover. However, as per IOSCO paper on liquidity risk management for collective investment schemes (CIS), these side pockets should not be managed in such a way that the investment strategy relies on the availability of these measures in case of illiquidity concerns. 


Side pocketing comes behind a series of landmark regulatory changes relating to the industry in 2018: Re-introduction of long-term capital gains (LTCG) tax for equity oriented funds, re-categorisation of mutual fund categories, Total Return Index (TRI) benchmarking, reduction in total expense ratio (TER), and the transition to full trail model of commission for intermediaries. These fundamental changes would have a lasting impact on all market participants. With the regulator pushing towards a clear demarcation between distribution and advisory based model, the industry is expected to move towards the latter, albeit gradually. Technology would play an important part in optimising the operational cost and efficiency in investment planning. 


The reduction in the TER will have a significant bearing on the intermediaries. They will now have to relook existing business models with an eye on research oriented solutions for investors. The reduction and rationalisation of expenses, coupled with full trail model of commission, will also augurs well for the investors, both in terms of return optimisation byinstilling the habit of long term investing.