Side Pocketing

Side pocketing is a mechanism used by fund managers to separate illiquid or distressed assets from the main portfolio, allowing investors to redeem shares while preserving the value of the remaining assets.
Side Pocketing
3 min
24-May-2024

Side pocketing, or segregated portfolio, is a segregation process wherein illiquid and distressed assets are isolated and separated from the more liquid assets. This process allows the division of your mutual fund investment portfolio and a side pocket is created by forming a separate portfolio for your distressed, hard-to-value, and illiquid assets.

The emergence of the concept of side pocketing was the result of consultations that had followed the 2008 global financial crisis that had caused a liquidity crisis in the Indian market and led to huge redemption pressure on mutual funds. The Securities and Exchange Board of India (SEBI) eventually allowed the mutual funds to segregate illiquid assets in 2019.

What Is side pocketing in mutual funds?

Side pocketing in mutual funds is simple to understand and refers to a segregation mechanism that allows investors to separate illiquid, distressed and hard-to-value assets from more liquid assets. Side pocketing in mutual funds, thus, prevents the distressed and illiquid asset in mutual fund schemes from damaging the returns that are generated by more liquid and healthy assets.

How does side pocketing in mutual funds work?

An Asset Management Company (AMC) decides on creation of side pocketing, or segregated portfolio, on the day of credit event. The AMC is then to follow a preset course, first to seek a prior approval of the trustees and immediately issue a press release to announce its intention of creating a segregated portfolio.

Once the trustee approval is received, which is to be done within one working day, side pocketing comes into effect from the day of credit event. The AMC then has to issue another press release with all the relevant information about the segregated portfolio and also inform the unit holders about the scheme via SMS and email.

What is the impact of side pocketing on NAV?

NAV refers to Net Asset Value and is the price per share of a mutual fund. Once the process of side pocketing is implemented, it effectively splits the NAV. As the side pocketing process segregates the illiquid and distressed assets from the liquid and healthy assets, the NAV is decreased and refers only to the value of liquid and healthy assets.

Does side pocketing safeguard investors?

Side pocketing in mutual funds is an effective risk management mechanism that is implemented to safeguard the interest of investors. It allows value preservation of the main portfolio that consists of liquid and healthy assets. The side pocketing in mutual funds thus ensures that the unhealthy assets do not create problems for the investor.

Also, the guidelines direct the AMCs to disclose the Net Asset Value of the segregated portfolio on a daily basis that ensures transparency and lets investors make informed decisions and efficient mitigation of liquidity risks.

Will side pocketing encourage fund houses to take more credit risk?

There is a definite provision that fund houses, or Asset Management Companies, should not take undue credit risks because of the existence of the provisions of segregated portfolio. The regulatory body has specifically warned that the misuse of the side pocketing provision would be considered serious and stringent action may be taken against the fund house for taking undue credit risk.

Recent development in side pocketing

On November 1, 2023, the regulatory body SEBI announced several changes related to mutual funds. It also included changes related to the creation of side pocketing, or segregated portfolio. The SEBI directed that the creation of a segregated portfolio shall be optional and at the discretion of the AMC. That the segregated portfolio should be created only if the SID of the scheme has enabling provision for a segregated portfolio with detailed disclosures made in SAI. The SEBI also directed that all new schemes shall have the enabling provision included in the SID for the creation of a segregated portfolio.

Disadvantages of side pocketing

One of the biggest disadvantages of side pocketing in mutual funds remains that it is a comparatively new intervention in the market and therefore fund managers may not be sufficiently experienced with properly dealing with this concept. This may be more true of novice fund managers who may find it difficult to identify and hold distressed assets.

Another disadvantage associated with side pocketing is that it puts a part of your investment into a freeze, which may end up creating confusion and mistrust between the investors and fund houses.

Conclusion

Mutual funds are a great way of investing, however they are averse to market risks. A way to mitigate these risks is by side pocketing the bad assets and keeping the good assets separate which will ease the liquidity and redemption processes.

If you want to invest through SIP or lumpsum investment in mutual funds, you must understand the risks associated with it and comprehensively compare mutual funds to select the ones best suited to your investment goals. The Bajaj Finserv Mutual Funds Platform, with over 1,000 mutual funds to choose from, is a perfect place to begin your investment journey.

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Frequently asked questions

What is side pocketing?
Side pocketing means to segregate illiquid and unhealthy assets from liquid and healthy assets.
What is side pocketing in Mutual Funds?
Side pocketing in mutual funds means to create a separate portfolio for illiquid and distressed assets while keeping the more liquid assets in a main portfolio.
What are side pockets for?
Side pockets are meant to safeguard the investors from any liquidity crisis that can arise from inclusion of illiquid asset in the portfolio.
What are side pockets called?
Side pockets is also called as segregated portfolio.
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Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

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