What is Side Pocketing in Mutual Funds

Besides the inherent market risk, a major one is credit risk — when a company or issuer fails to repay the money borrowed from the fund. This can negatively impact the fund’s Net Asset Value (NAV) and create panic among investors.

To tackle this, regulators introduced side pocketing in mutual funds, a strategy that separates troubled assets from the main portfolio. This helps protect investor interests and prevents sudden market reactions that could harm the entire fund.

Let’s learn what side pocketing is, how it works, its benefits and drawbacks, and its impact on investors. 
*This article is for information purposes only and is relevant to the Indian market*

Key Takeaways

• Side pocketing segregates risky assets from liquid mutual fund holdings
• Introduced by SEBI in 2018 after the IL&FS crisis
• Two NAVs are created —one for liquid assets, one for distressed assets
• Investors cannot redeem from side-pocketed assets until recovery
• Side pocketing prevents unfair gains/losses for new investors
• SEBI regulations ensure transparency and prevent misuse

Why Was Side Pocketing Introduced?

The concept became crucial after the IL&FS crisis in 2018. Many debt mutual funds had invested in IL&FS bonds, which suddenly turned into non-performing assets due to the company’s financial troubles. 

This led to —

• A sharp drop in NAVs, causing panic among investors
• A wave of redemptions, forcing fund houses to sell their best assets to repay investors
• A loss of confidence in debt mutual funds as a safe investment

To prevent such situations in the future, SEBI (Securities and Exchange Board of India) allowed mutual funds to use side pocketing. Now, instead of liquidating good assets to cover losses, funds can separate the troubled assets and manage them independently.

How Does Side Pocketing Work in a Mutual Fund?

Here’s the step-by-step process —

• Identification of Distressed Assets: If a security in a debt mutual fund gets downgraded due to default risk, the fund house identifies it for side pocketing
• Creation of a Separate Portfolio: The troubled assets are moved into a segregated portfolio, leaving the main portfolio unaffected
• NAV Split: The mutual fund now operates with two separate NAVs –
  • One for healthy assets (liquid investments)
  • One for side-pocketed assets (illiquid and risky investments)
• Restriction on Redemptions: Investors cannot redeem units from the side pocket until the distressed asset is resolved or recovered
• Future Recovery: If the asset recovers in value, existing investors benefit based on their original holdings

Example of Side Pocketing in Action

Suppose XYZ Debt Fund’s assets under management (AUM) stand at Rs. 20 crores on a particular date.

You cannot invest or redeem from the side-pocketed corpus of Rs. 4 crore. However, you can continue your investing and redemption activities from the Rs. 16 crore liquid corpus.

Benefits of Side Pocketing

You will enjoy the following perks -

Protects the main fund’s NAV from volatile assets

Reduces panic withdrawals by ensuring stability

Prevents new investors from unfairly benefiting from future recoveries

Limits continuous negative impact on the portfolio

Fund managers can work on reviving troubled assets without affecting the liquid portion of the fund

Drawbacks of Side Pocketing

• Illiquidity Issues: You cannot redeem money from the side-pocketed portion until recovery
• Valuation Uncertainty: Side-pocketed assets may be difficult to accurately price
• Operational Complexity: Managing two NAVs increases administrative burdens for fund managers
• Possibility of Misuse: Some fund managers might use side pocketing to hide poor investment decisions
• Investor Frustration: The wait for asset recovery could be long and uncertain

Impact on Mutual Fund Investors

For Existing Investors

• Protects their liquid investments from risky assets
• Ensures they benefit if the distressed asset regains value

For New Investors

• They don’t inherit the risks associated with previously side-pocketed assets
• They can invest with better transparency in fund holdings

For Fund Managers

• Helps manage credit risk efficiently
• Reduces redemption pressure during crises

For the Mutual Fund Industry

• Enhances investor trust in debt mutual funds
• Provides a structured approach to handling bad debts

Guidelines on Side Pocketing

There are some strict regulations to ensure transparency and prevent misuse —

1. Not Compulsory: Fund houses can choose whether or not to create a side pocket
2. Mandatory Disclosure: Fund houses must disclose the NAV of segregated portfolios daily
3. No Fresh Investments: New investors cannot invest in side-pocketed assets
4. Exit Window: Investors get a 30-day exit period when side pocketing is implemented
5. Valuation Oversight: Regular monitoring and fair valuation of side-pocketed assets

Wrapping Up

Side pocketing is a valuable risk management tool in debt mutual funds. It protects investor interests by isolating risky assets, which ensures that healthy investments remain unaffected. However, investors must remain cautious as side-pocketed funds are illiquid and may take time to recover.

Before investing in a mutual fund, check its past performance, credit risk strategy, and the fund house’s stance on side pocketing. While it provides stability during financial distress, it is not a foolproof solution. Always diversify your portfolio to mitigate risks effectively.

Frequently Asked Questions