Recently, market regulator Securities and Exchange Board of India has allowed debt mutual funds to adopt “side pocket” that will allow fund managers to separate their stressed assets from the portfolio.

The SEBI move is on the back IL&FS fallout, which had failed in meeting its commitments to creditors and lenders, putting a lot of pressure on the net asset value of most debt funds that owned IL&FS group papers in their portfolio.

IL&FS-type issues are not new to Indian investors and debt funds. A couple of years back, Amtek Auto’s debt instrument was downgraded by credit rating agencies. JPMorgan India Treasury Fund and JPMorgan India Short Term Income Fund, which were holding Amtek Auto’s debt paper, were forced to suspend redemptions in the units causing panic among investors.

So, to protect retail investors from the risky investments that are causing huge disruptions, SEBI has allowed MFs to separate the stressed assets from good quality liquid assets. Once the toxic papers, which are facing a default threat, are demerged into a separate asset, the rest of the portfolio will be traded at a separate NAV based on the underlying (monetisable) assets. There will be two NAVs on such schemes and retail investors can redeem or hold on to the main scheme, according to their wish or need, thus ensuring protection at least to a part of the investment.

While this is a welcome move, there are some hidden risks too. As the NAV of the fund is split, investors may find it difficult to track both. Besides, ascertaining the fair value of the NAV of the stressed asset can be difficult, since the valuation of the illiquid asset may be contentious. Also, it may take years for the stressed asset to be realised or wound up.

There are fears too that side-pockets might be misused by fund managers.

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