This article is a case study of how the degree of risk in an investment can suddenly change. An investment that is considered safe can almost overnight become a dead investment and investors lose in the resulting volatility of price fluctuations.

The financial sector knows how to hide truth

Whatever else one may say of the financial sector, the one thing that makes the sector colorful is their creative ability to churn out words and phrases that describe a certain concept or action. For instance the writing off the loans given to industrialists and big business is called “hair-cut”. Suppose a business has taken a bank loan of Rs.100, and is offering to repay Rs. 20, in full settlement of the entire loan, then Rs. 80 is the hair-cut that the business has taken or given, whichever way one wants to look at it. Mind you it is not referred to as a loan write-off by banks, it is called a hair-cut. The layman not knowing the meaning will never know that the business is not repaying 80 % of the money it owes the bank. Only in the world of finance that you come across such clever deception.

Now in mutual funds another colorful term has come into fashion. It is called ‘side pocketing’. Let me first explain the circumstances surrounding this term before I explain the term itself.

The circumstances that created the ‘side pocket’

In the recent past some very strong undercurrents have surfaced in the financial sector. It appears that the credit rating agencies ignored (either deliberately or unknowingly) that IL& FS was a sinking ship. IL & FS is the largest infrastructure financing company in India. They have a presence in almost all large infrastructure projects in India, where they have lent money in various forms with long term repayment contracts. It appears (from the moves initiated by the Government of India, which called for an investigation by the Serious Fraud Organisation) that the executives of IL & FS have been giving themselves hefty incomes, mis-managed asset liability matching, and as a result the company is now in the verge of becoming financially bankrupt. They have already defaulted in repayment of some loans that were due for payment. The credit rating agencies are under a cloud because even recently (just before the first default by IL & FS) they gave a AAA rating to IL & FS. A triple-A rating means that if you are planning an investment in IL & FS, you can consider it to be a safe investment. A few weeks after the AAA rating suddenly IL & FS has become a defaulting company and therefore a very high-risk investment. IL & FS is now defaulting on the loans it has taken to operate its business.

For its size and its reputation , it is difficult to imagine that IL & FS can be be in this situation. So mutual fund managers went about investing a lot of money from their funds in IL & FS. It seemed a very safe investment to the financial analysts and fund managers. With IL & FS turning untouchable, the fund managers do not know what to do with the investments already made. Since the value of IL & FS shares and debentures have fallen drastically, the value of IL & FS investments held by mutual funds has also fallen drastically. The result – NAVs of mutual funds have fallen.

Mutual funds are concerned. If they let things be as they are (with worthless IL & FS investments remaining in their portfolio), the return on the mutual funds will suffer. If they try to sell the investments in the market, they will not get a good price – again the return will suffer. Mutual funds can neither sell nor keep IL& FS investments, since they are worthless today. So they invented the ‘side-pocket’.

What is a side pocket?

SEBI has agreed in principle, that mutual funds exposed to IL & FS investments, can separate the entire investment from the remaining investments in the fund and place it in a separate account – this is called side pocketing. That is take the failed investment out of the main basket and put it in another basket or to use the current jargon put the investment in a side pocket.

What this action does is the mutual fund can now report its NAV without having to consider the toxic IL & FS investments. So the unit holders in the fund can get the advantage of better NAVs, by not accounting for the value of IL & FS investments in NAV calculations. In calculation of the new NAV the value of all other investments in the fund are included. The side-pocketed IL & FS investments continue to stay in the side pocket till such a time as those investments start giving returns.

The creativity of the world of finance, apart from coining the term side pocket, is also in finding a way to brush unpleasant things under the carpet. Trust the financial sector to hide unpleasant truths.

The truth is that an investment that was for decades perceived as low risk by the financial analysts and market experts has suddenly become very risky. And the truth is whether the investment is side pocketed or not, the mutual fund investor is in a loss because of this risk. Side pocketing does not mean that the fund is making profits. It only means that the dirty clothes have been kept aside for the moment, hidden from public view. Given the current financial health of IL & FS it is unlikely that the company will recover very soon. The dirty clothes will have to hidden for a very long time.

Side pocketing creates a higher investment risk to the fund portfolio

One day the dirty clothes will have to washed or shown to the world as being dirty. Since IL & FS was considered a safe bet by fund managers earlier, a lot of funds were invested in that company. When a significant portion of the money in a mutual fund is side pocketed (IL & FS was a favorite investment for most fund managers), the fund’s portfolio now (after side pocketing) consists of a lop-sided (or skewed) portfolio that is more risky.

For example, suppose a fund’s portfolio has a total of Rs.100 in investments of which (in a return-optimizing, risk-diversified portfolio) the fund manager had decided that IL & FS consists of lower risk (because of the perceived strong fundamentals of that company) and therefore Rs. 20 should be invested in IL & FS, with the remaining Rs. 80 invested in higher risk investments of other companies. If Rs. 20 of IL & FS is side pocketed, what remains in the portfolio is Rs. 80 – all of which is now more risky. So portfolio that was less risky becomes more risky

Side pocketing creates a Moral Hazard

Side pocketing also creates a moral hazard. With an easy solution available to fund managers  to side pocket investments that have gone sour, there is a high possibility that fund managers will not worry as much to ensure that financially prudent investments. If an investment they have made gets into a loss, they only have to side pocket the investment and continue merrily as if nothing went wrong. And all the while the mutual fund investor has the bear the higher investment risk and the consequent higher probability of loss. The fund manager will continue to get his or her incentives and go laughing all the way to the bank.

Statistical sophistication of risk analysis is not required for individual investors

This brings us to the first principles of investment for individuals. No matter how the risk is hidden, the risk exists in all investments where the invested money is parked in companies. Whether the companies are big or small, whether they are currently financially strong or not, whether the money is invested in debt or equity. Hard earned money, earned by individuals, is better off invested in low risk investments such as banks, post office, etc. for short term and in life insurance or provident fund for the long term. At best an investor with a good degree of risk appetite may assign a portion of his or her investments to risky investments. The hair-splitting of risk by using the beta or some other statistical indicator is best left to academicians who try to make a career out of it. For individuals who wish to save and invest it is plain common sense. Individuals need answers for questions such as: Will my money be safe? After how many years will I need money in my financial planning?, etc.

Financial planning for individuals is application of common sense and a discipline of saving, not sophisticated and esoteric mathematical formulas