SEBI is likely to introduce side-pocketing in mutual funds. This was discussed at the second meeting of Mutual Fund Advisory Committee (MFAC) this month to discuss rules governing debt funds, said two people who attended this meeting.
An MFAC member told Cafemutual, “Nothing has been finalized but SEBi is keen to introduce side-pocketing in mutual funds. In fact, SEBI will formulate rules and regulations on sidepocketing once MFAC gives a roadmap on how to go about it.”
Side-pocketing is a practice in which fund houses can segregate risky assets from the rest of their holdings and cap redemptions. Simply put, fund houses can create two funds - one with risky assets where fund house will not allow redemption expecting recovery from stressed assets and another fund with other assets with existing features. This practice is prevalent among hedge funds in developed markets.
Another key development is introduction of mark-to-market valuation for all debt securities. This means fund houses may have to do mark-to-market valuation of debt securities having maturity of less than 60 days.
Currently, SEBI rules says that fund houses have to do mark-to-market valuations of securities having maturity of 60 days and more. Liquid funds hold securities having maturity of up to 91 days. However, most liquid funds hold securities having maturity of less than 60 days. As a result, post IL&FS crisis, NAVs of only 4 liquid funds witnessed a sharp decline due to mark-to-market loss.
Since debt securities are illiquid in nature and not traded like equities, mark-to-market valuation is challenging for fund houses since they have to quote NAV on a daily basis. Hence, most fund houses rely on rating agencies to derive NAV. Often rating agencies look at accrual to value debt securities. Credit rating agencies reflect the rating agencies’ opinion about the credit risk of debt securities based on historical data and some assumptions about the future, which some experts say, underplays the possibility of default.
