What is Side Pocketing in Mutual Funds?

Debt mutual funds are often considered less risky than those that invest in the equity market. However, they are not entirely free from risk. Mutual funds with debt securities have to deal with the risk of losing value due to illiquidity or the inability of the issuing company to repay its investors.

To prevent such events from bringing down the value and returns of a debt-focused fund, the Securities and Exchange Board of India (SEBI) introduced side pocketing in mutual funds in 2018. It is a technique that allows asset management companies (AMCs) to effectively manage distressed and illiquid debt assets in their portfolio.

In this article, we will explore what side pocketing in mutual funds is, how it works, its various advantages and the impact on a fund’s NAV.

Side Pocketing in Mutual Funds Meaning

Side pocketing in mutual funds is a mechanism that asset managers use to separate distressed or illiquid assets from the rest of the portfolio. This technique is usually used when a specific debt security in a mutual fund faces credit downgrades, liquidity issues or defaults.

By separating such problematic assets, fund managers can protect the existing investors from sudden drops in the fund’s Net Asset Value (NAV). One of the highlights of side pocketing in mutual funds is that only the existing investors are exposed to the side-pocketed assets. New investors who invest after the side pocketing exercise do not gain any exposure to the distressed assets.

If the distressed assets and illiquid recover in the future, they are liquidated and the proceeds are distributed to the existing investors in the proportion of their investment.

How Does Side Pocketing in Mutual Funds Work? 

Now that you know what side pocketing in mutual funds is, let us try to understand it better with a hypothetical example.

Assume you invest in a debt mutual fund. The fund holds bonds of a company named ABC Ltd. Due to certain unavoidable issues, the company becomes financially distressed and defaults on its payments. As a result, the bonds of ABC Ltd. are downgraded and lose their value, making them illiquid.

The debt mutual fund’s manager decides to “side pocket” the bonds of ABC Ltd., thereby separating the bonds from the main portfolio. The existing investors, such as yourself, receive units in both the main fund and the side pocket.

The fund’s net asset value is also adjusted to reflect only the liquid and healthy assets in the portfolio. If the distressed bonds of ABC Ltd. recover in value or are liquidated at any time in the future, the proceeds are distributed among the existing investors.

Now, investors who invest in the debt mutual fund after the side pocketing event will not gain any units of the side pocket. As a result, they will not be eligible to receive the proceeds arising from the recovery or liquidation of ABC Ltd.’s bonds.

Side Pocketing in Mutual Funds and Its Impact on the Net Asset Value 

Side pocketing in mutual funds has a direct impact on the fund’s net asset value. When an illiquid or distressed security is moved to a side pocket, the NAV of the fund decreases. This is because the portfolio no longer includes the distressed asset. Meanwhile, the side-pocketed asset is assigned a separate NAV, which is often significantly lower due to it being distressed.

For example, if a mutual fund’s NAV is ₹100 and a distressed asset worth ₹20 is side-pocketed, the new NAV of the main portfolio would drop to ₹80. The side-pocketed asset’s NAV will be determined depending on the estimated recoverable value of the asset, which is often much lower than ₹20 or in some cases even zero.

However, if the side-pocketed asset recovers or is successfully liquidated, existing investors may receive a portion of the invested amount.

Advantages of Side Pocketing in Mutual Funds 

Side pocketing in mutual funds is a highly useful exercise that benefits fund managers, existing investors and new investors. Here is a more in-depth overview of some of its key advantages.

• Protects New Investors 

Side pocketing in mutual funds ensures that new investors do not gain any exposure to distressed assets by segregating them from the main portfolio. This way, new investors are protected from having to share losses with existing investors.

• Ensures Fair Treatment

Side pocketing in mutual funds ensures that the proceeds from the recovery or liquidation of the distressed assets are restricted to investors who were part of the fund when the segregation occurred. This prevents new investors from unfairly benefiting from the eventual recovery of the side-pocketed assets.

• Enhances Transparency 

Side pocketing in mutual funds is a highly transparent exercise where the fund managers clearly communicate the details of the assets being segregated to the investors. Furthermore, it also creates clarity about the health of the fund and allows new investors to make informed investment decisions.

• Prevents Panic Redemptions 

By segregating distressed assets, fund managers can stabilise the NAV of the main fund. This could potentially reduce panic-driven redemptions from existing investors due to the

• Gives Time for Recovery 

Segregating distressed assets provides fund managers with time for recovery, which can often take months to years. If the segregated asset regains value, investors can recover some or all of their losses.

Conclusion 

Side pocketing in mutual funds is more than just an accounting technique. In fact, it is a highly useful risk management tool for asset managers that can help safeguard the interests of investors by isolating distressed assets from well-performing ones.

Although the technique has its advantages, it also has certain drawbacks. The assets that were segregated due to side pocketing in mutual funds may not always yield any value to the investors.

Therefore, as a mutual fund investor, you should always assess the risk factors thoroughly before investing in funds that are prone to credit defaults to safeguard your investments.

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