All You Need to Know About Side Pocketing in Mutual Funds

When a mutual fund holds assets that suddenly turn risky or become hard to sell, it can impact all investors in the fund. That’s where side pocketing comes in. It’s a way to separate the troubled assets from the rest of the portfolio. So, every day, investors aren’t affected by defaults or delays.

Read on to understand how side pocketing in mutual fund works and why it matters.

What is Side Pocketing?

Side pocketing is a tool used by mutual fund houses to separate stressed or illiquid assets from the rest of the portfolio. It’s like creating a separate drawer to store investments that are in trouble. So they stay separate from the healthy part of the fund that continues to operate normally.

This feature is used mostly in debt mutual funds. When a bond in the fund’s portfolio starts showing signs of trouble, like payment delays or default, fund managers shift that part into a ‘side pocket’.

Once that happens:

• New investors can’t enter just to profit off the undervalued asset
• Existing investors get proportionate units in the side pocket
• The main fund continues to operate normally with healthy assets

This way, side pocketing protects long-term investors and prevents sudden exits or panic.

How Does Side Pocketing Work?

Let’s assume a debt mutual fund invests in 20 bonds. If one of those bond issuers defaults, the fund house moves that bond into a side pocket.

Here’s what happens next:

• The defaulted bond is carved out and placed into a separate portfolio.
• Your existing mutual fund units are adjusted. You now hold 2 sets, the main fund and one for the side pocket.
• The value of the side pocket depends on whether the troubled asset recovers anything.
• If the issuer pays back later, the recovered amount is credited to your side pocket units.

You can’t sell or redeem the side pocket part until recovery happens. But your remaining fund units stay active and unaffected.

When is Side Pocketing Used?

Side pocketing is used in cases like:

• Credit downgrades: When a rating agency lowers a bond’s rating due to poor financial health
• Payment delays: If an issuer misses an interest or principal repayment
• Default events: Complete default on debt obligations

It’s not used for short-term volatility or market-driven price changes. Only significant credit events trigger side pocket creation.

Key Features of Side Pocketing in Mutual Funds

Here’s a quick overview of the key features:

• Applies only to debt mutual funds: Especially ones holding corporate bonds
• Not automatic: Fund houses need to inform investors and take approval
• No redemption or switch allowed: You can’t redeem the side pocket units until recovery
• NAV splits: The fund shows 2 NAVs (Net Asset Values). One for the main portfolio and another for the side pocket. So you can see their value separately.

Why Do Fund Houses Use Side Pocketing?

Side pocketing is not a default option. It’s used only in specific cases when an investment is no longer performing well and creates risk for the whole fund.

Here’s why it helps:

• Protects investor interest: New investors can’t misuse a fallen NAV to gain unfair profits
• Limits panic withdrawals: Stops investors from pulling out money just because one asset turned risky
• Offers recovery chance: If the troubled company repays later, that value is returned to the rightful holders

SEBI (Securities and Exchange Board of India) has allowed side pocketing in debt funds since 2018. This move came after major credit events involving IL&FS (Infrastructure Leasing & Financial Services) and DHFL (Dewan Housing Finance Corporation Limited). Both companies defaulted on their debt, causing heavy losses in the mutual fund space, highlighting the need for better risk handling.

Benefits and Risks of Side Pocketing

Side pocketing comes with its share of pros and cons, knowing both can help you make informed decisions as an investor.

Benefits

• Investor protection: Keeps investors safe from risky assets
• Reduces volatility: Main NAV becomes more stable after removing the risky portion
• Transparent recovery: Any recovered money from the side pocket goes to existing unit holders

Risks

• No immediate exit: You can’t redeem side pocket units until recovery
• Uncertain timeline: There’s no fixed period; it depends on the asset’s legal and financial resolution
• Reduced liquidity: Your total fund value may go down if the side pocket has a large share

What Should You Do as an Investor?

Here are a few simple things to keep in mind if your mutual fund announces a side pocket:

• Don’t panic: Side pocketing is meant to manage risk, not create it
• Track updates: Fund houses share updates regularly on asset status
• Avoid impulse exit: Redeeming your main fund units in a rush may lead to a loss
• Consult a financial advisor: They can help assess the long-term impact on your investment

If you stay invested and the issuer repays, you will benefit from the recovery, unlike someone who exited early.

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FAQs on Side Pocketing in Mutual Funds

What are side pockets in funds?

Side pockets are separate portfolios within a mutual fund created to hold stressed or defaulted assets. They help isolate these assets from the rest of the fund. The main aim is to protect existing investors from further loss or risk.