What Is Side Pocketing in Mutual Funds? (Explained With Examples)

Debt mutual funds are often considered to be low-risk avenues for investors who are looking to earn a fixed income. Although debt mutual funds carry lower risk, they are not completely risk-free.

Their primary risk arises from credit risk, where the value of fixed-income instruments held by a debt mutual fund could see a sharp fall if the issuer’s financial health worsens or even becomes zero in case of default.

Previously, a credit risk event arising out of a single issuer could affect the entire portfolio of a debt fund. To tackle this problem, a solution was created: side pocketing. 

In this article, we learn about what is side pocketing in mutual funds and how it can impact your investments.

What is Side Pocketing?

In 2018, the IL&FS crisis raised alarms regarding investing in debt securities. Consequently, the Securities and Exchange Board of India (SEBI) gave the green signal to set up a side pocket for mutual funds that have exposure to debt instruments.

Side pocketing refers to the accounting technique in which mutual funds having debt exposure segregate the low-quality assets in their portfolio. Side pocketing in mutual funds protects distressed assets from impacting the overall portfolio by separating them from liquid assets.

What are Distressed Assets?

Distressed assets refer to an asset that is facing credit, financial, or operational risks. The impact of the risks forces the owner of the assets to sell the asset, usually at steep discounts. Distressed assets include assets such as bad debts of banks, fundamentally weak companies, and corporate bonds.

How Does Side Pocketing Work?

Before understanding how side pocketing in mutual funds works, it’s important to know what NAV is.

The net asset value, or NAV, refers to the market value or price of a unit of a mutual fund scheme.

Side pocketing is the process of separating illiquid or distressed assets from liquid assets. Through this accounting technique, a mutual fund splits its NAV into two. One NAV represents the healthy and liquid assets in the fund while the other NAV represents the side pocket of the illiquid and distressed assets.

By splitting the NAV into two parts, the fund can protect the healthy assets while separating the illiquid assets. If a debt security in the side pocket receives a downgrade or defaults, its impact is limited only to the NAV of the distressed asset.

Let’s look at an example to  better understand side pocketing:

• ABC is a debt fund with assets under management (AUM) of Rs 10 crore.
• A few debt securities amounting to Rs 2 crore in the fund’s portfolio are downgraded to the default category.
• Following this, the fund creates a side pocket for the impacted assets.
• Through side pocketing, the NAV is split into two parts. One NAV for the liquid and healthy assets amounting to Rs 8 crore, and the other NAV for the low-quality assets amounting to Rs 2 crore.

By creating the side pocket, investors will know that their NAV from the healthy part of the investment book is safe even as the debt fund makes efforts to best manage the illiquid assets. 

How Does Side Pocketing Help Investors?

The creation of a side pocket helps in mitigating the impact of credit risks. Here are some of the major ways in which side pocketing impacts mutual fund investors:

Preserves Value

In the case of an adverse event, several investors might redeem their units. In such cases, a fund will have to sell its healthy assets. However, a side pocket separates the illiquid assets from the healthy assets in order to stabilise the NAV of the scheme which reduces the impact of any large redemptions.

Although side pocketing offers several benefits to investors, a disadvantage is that it results in the freezing of a part of the investment. As a result, investors are unable to redeem funds from the segregated assets.

Scope for Recovery

Since a side pocket separates the distressed securities from the healthy ones, funds can also have a heightened focus on recovering the impacted securities. By restructuring deals or making use of recovery strategies, the funds can make efforts to recover the impacted assets.

Transparency

Side pocketing provides higher transparency and information regarding illiquid securities. An investor can track the status of the distressed assets and get further clarity regarding the risks involved with the investment.

How Side Pocketing Impacts Mutual Funds?

The mechanism of side pocketing in mutual funds helps protect investors from a credit risk event. At the same time, the creation of a separate portfolio of distressed assets allows the funds to narrow down their focus and make efforts to recover funds from the unhealthy securities.

SEBI has also laid down certain guidelines that direct mutual funds to disclose the NAV of the segregated portfolio daily. The regulatory body has also warned mutual funds against the misuse of side pocketing.

However, side pocketing is a relatively new mechanism. The lack of experience of using it might result in the mechanism not being utilised to its full potential.

Conclusion

Debt mutual funds can be an ideal investment option for risk-averse investors. With mechanisms like side pocketing in place, fund houses can mitigate the risks associated with debt securities. Side pocketing not only allows mutual funds to protect their healthy assets but also helps in safeguarding investors.