Side Pocketing

Side pocketing is an accounting technique used by mutual funds to separate distressed assets from the rest of the fund. It's an emergency measure that protects investors' interests in debt funds by preventing distressed assets from affecting the returns of the more liquid assets.
What is Side Pocketing in Mutual Funds
3 min
22-October-2024

Side pocketing in mutual funds refers to the practice of segregating illiquid or distressed assets from the main portfolio, creating a separate portfolio for these hard-to-value holdings. This approach allows fund managers to isolate troubled assets, enabling better management of liquidity for the rest of the investment. Side pocketing helps protect investors from potential losses due to illiquid assets while allowing the fund to focus on more stable investments. In this article, we will explore what side pocketing is, how it works, its advantages and disadvantages, and its impact on mutual fund investments.

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.

Importance of side pocketing

Side pocketing plays a crucial role in managing mutual funds, particularly during times of financial distress. By isolating illiquid or distressed assets from the main portfolio, it helps protect the interests of existing investors. When such assets are segregated, the fund can prevent unfair dilution of returns, ensuring that investors who remain invested do not suffer losses due to redemptions prompted by illiquid holdings. This approach becomes especially relevant during market downturns when liquidity issues arise.

Additionally, side pocketing allows fund managers to adopt a more focused strategy for the troubled assets. By segregating them into a separate portfolio, they can manage recovery efforts more efficiently and seek potential opportunities to unlock value. This can involve waiting for market conditions to improve or working towards asset recovery, which might otherwise be difficult when mixed with the liquid part of the portfolio.

Moreover, side pocketing instils investor confidence by providing transparency and a structured approach to managing troubled assets. It reassures investors that there is a clear plan for handling illiquid securities, which may help reduce panic-driven redemptions. The practice, therefore, adds a layer of protection to mutual funds by balancing the need for liquidity and long-term value preservation.

Importance of side pockets in debt mutual funds

Side pockets are particularly significant in debt mutual funds, where the risk of encountering illiquid or distressed securities is higher. By segregating troubled assets from the main portfolio, side pockets help protect investors from potential losses due to defaults or credit downgrades. This separation ensures that the impact of such events does not affect the returns of the entire fund, thereby safeguarding the interests of investors who remain invested, while allowing time for the recovery of distressed assets.

Moreover, side pockets enable fund managers to focus on resolving issues specific to the troubled debt securities without compromising the liquidity and performance of the rest of the portfolio. This targeted approach facilitates better management of credit risk, as fund managers can work towards recovery strategies or wait for improved market conditions for these illiquid assets. It also provides an opportunity for the gradual realisation of value from distressed securities over time.

Furthermore, the use of side pockets enhances transparency in debt mutual funds by clearly identifying and separating high-risk assets. This transparency boosts investor confidence, as it demonstrates a proactive approach to managing credit events and ensures a fair distribution of returns. Ultimately, side pockets help maintain stability in debt mutual funds by mitigating risks associated with illiquid debt instruments.

Benefits of side pocketing for investors

Side pocketing offers several benefits to investors, especially in mutual funds that face liquidity issues or credit events. By separating distressed or illiquid assets from the main portfolio, this practice provides a structured approach to managing risk and enhancing investor protection. Here are some key benefits for investors:

  • Protection from losses: When illiquid assets are side-pocketed, investors are shielded from sudden losses that could arise due to redemptions triggered by the troubled holdings. This ensures that the impact of distressed assets is contained, preserving the value of the liquid portion of the fund.
  • Fair treatment: Side pocketing ensures fair treatment of all investors by preventing an uneven distribution of losses. Investors who exit the fund do not unfairly impact those who remain, as the side-pocketed assets are kept separate from the primary portfolio.
  • Focused recovery efforts: With a distinct portfolio for distressed assets, fund managers can concentrate on recovery strategies without affecting the main portfolio's performance. This can involve waiting for better market conditions or negotiating restructuring deals.
  • Increased transparency: The use of side pockets provides greater clarity on the status of troubled assets, allowing investors to better understand the risks associated with their investments and making informed decisions.

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.
What is side pocket realisation?

Side pocket realisation refers to the process of liquidating or recovering the value of assets that have been placed in a side pocket. When distressed or illiquid assets are eventually sold or their value is restored, the proceeds from these assets are distributed to investors according to their respective holdings in the side pocket, separate from the main portfolio.

What is the difference between a side letter and a side pocket?

A side letter is a private agreement between a fund manager and specific investors that outlines terms and conditions not included in the main offering document. In contrast, a side pocket involves the segregation of illiquid or distressed assets within a fund to protect investors from losses. While both mechanisms offer tailored solutions, they serve different purposes.

Is side pocketing common across all types of mutual funds?

Side pocketing is not common across all types of mutual funds. It is primarily used in funds dealing with illiquid assets, such as certain debt or hedge funds, where distressed securities may arise. Equity mutual funds typically do not utilise side pockets, as their assets are generally more liquid, making the practice less relevant in that context.

How long does the side pocketing process typically last?

The duration of the side pocketing process varies depending on market conditions and the nature of the distressed assets. It can last anywhere from several months to a few years, as fund managers seek to recover value or wait for better market conditions. The timeline is influenced by the asset's recovery potential and broader economic factors.

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Disclaimer

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. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.