How does side pocketing work?

Sometimes described as segregation of portfolio, Side Pocketing is defined by SEBI as, "mechanism to separate distressed, illiquid and hard-to-value assets from other more liquid assets in a portfolio." Put simply, it allows a Debt Mutual Fund to keep the bad assets away from the good ones.

The need for side pocketing

A Debt Mutual Fund is a collection of bonds, debentures, and other instruments that provide a fixed income. Occasionally, due to some event or poor business performance, the issuer of these instruments defaults on its payment or sees a downgrade of its credit rating. Depending on how much money can be recovered, the Fund Manager writes off a certain part of the bad asset, thus impacting the total NAV. The fall in NAV encourages some investors to redeem their investments early which hurts the interests of those who stay invested. Let's explain this with an example.

By keeping aside the bad asset, side pocketing protects interest of investors in debt mutual funds.

Suppose you have a debt Mutual Fund with an NAV of Rs. 50. In this, a certain investment -- which comprises Rs. 5 or 10% of the entire investment -- becomes a bad asset and the fund manager has to write off 50%. In other words, the fund manager expects the issuer to repay only 50% of the money. This brings down the NAV to Rs. 47.5, a fall of 5%. In such situations, many investors would exit the Mutual Fund at this reduced NAV which increases the share of such bad assets in the Mutual Fund. Secondly, if the issuer is not able to pay anything, the NAV falls further hurting the interests of investors who didn't exit. Conversely, if the issuer is able to pay more than what was written off, the new investors (the ones who came in place of those who exited) get an unfair advantage

How does Side Pocketing help?

In the above example, the Mutual Funds splits the original fund into two - the good or healthy asset with an NAV of Rs. 45 & the bad or stressed asset with an NAV of Rs. 5. The bad asset is segregated or kept aside and no transactions are allowed on it. If the AMC is able to recover some money, the units of the bad asset are automatically redeemed and the money is credited to the investor.

Side pocketing serves three objectives

1) Like any bank, no Mutual Funds wants a run or quick redemption of its assets, especially by large investors. By separating the good assets from the bad, this encourages people to stay invested.

2) By taking away the incentive to time their exit, this ensures fairness to all investors in a Mutual Fund.

3) The AMC can work on recovering the money from the stressed asset without any undue pressure from investors.

After many demands by investors, "Side Pocketing" was enabled as an optional emergency provision by SEBI in December 2018 in the wake of debt default by companies like IL&FS, DHFL and others. 

Recently, Reliance Mutual Fund and UTI Mutual Fund side-pocketed after Altico Capital was downgraded below investment grade. In January this year, Franklin Templeton side-pocketed bonds of Vodafone Idea in six of its debt schemes.