What is side pocketing in mutual funds?

Some fund houses have opted for the side pocket option for their debt schemes. It allows bad assets to be differentiated from other liquid investments from investments that are affected by the credit profile of the assets included in the portfolio.

Some fund houses have opted for the side pocket option for their debt schemes. Let’s know what is side pocketing and how to use it.

What is side pocketing in mutual funds?

The side pocket option allows fund houses to separate bad assets from other liquid investments from investments that are affected by the credit profile of the assets included in the debt portfolio. This process is beneficial because it protects small investors from the pressure on the fund in case of sudden exit of big investors. This stabilizes the Net Asset Value (NAV) of the scheme and reduces selling. In case of some assets being suddenly illiquid, side pocketing supports the liquid portfolio.

How does side pocketing in mutual funds happen?

Side pocketing is considered a change in the basic elements of the scheme. The Asset Management Company (AMC) has to make a proposal to make changes in the Scheme Information Document (SID) and create a side pocket to provide a 30-day unloaded exit window. After its approval on the day of the event, the AMC separates the securities in the illiquid or default category from other instruments. This creates two schemes – one has illiquid papers and the other has good securities.

How side pocketing is beneficial in mutual funds?

Suppose a fixed income fund has a corpus of Rs 1000 crore and 5% of its exposure is in a company that has defaulted. Due to the default of the company, many big investors start withdrawing from the scheme for fear that their losses may not increase due to the fall in the NAV. In order to pay investors, the scheme sells good securities in its portfolio, thereby increasing the proportion of bad assets in the portfolio. If bad asset is removed from the portfolio, there will be no panic in investors. Whenever there is an outstanding recovery from the defaulting company, it will pay the investors.

Why Side pocket is required?

For some reason, SEBI has not made side pocketing mandatory for all bonds that fall into non-investment grade security grade. This decision is left to the asset management company and their trustees. So whenever a bond slips into non-investment grade, some asset management companies write down its value while some pocket the side for it.

What is disadvantage of Side pocket in mutual funds?

Side pocketing requires caution. According to analysts, the valuation of illiquid or default assets is controversial, so the NAV of the illiquid asset cannot be ascertained. Secondly, it is difficult for investors to track two types of NAVs. Third, fund houses should not use side pockets to save managers ‘fees on more liquid assets or to cover poor performance assets or fund managers’ weak liquidity management.

What happens when a side-pocket is created?

The scheme separates its portfolio into the good portion, consisting of investment grade bonds, and the bad portion comprising the downgraded bond. The NAV of the scheme will be carved out to the extent of the value (after write down) of the bad bond. All existing investors in the scheme will receive one new unit in the side-pocketed portfolio in addition to existing units in the scheme.

No transactions are allowed in these new units. So, if you redeem the fund after side-pocketing, you will only receive the NAV of the main portfolio. But if the scheme eventually recovers money from the bond, they will get automatically redeemed and you will receive a payout. The trustees of the AMC are supposed to monitor the recovery of proceeds in the side-pocketed bonds.

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