Side pocketing in mutual funds: How it can help safeguard investor interest

As an investor in mutual funds, knowing how your investment is managed can give you greater understanding and make you more informed. One relatively nuanced concept is that of side pocketing, or segregation of portfolio – a mechanism that some mutual funds use to deal with distressed or illiquid assets and mitigate their impact on the portfolio. Read on to learn what side pockets are and why mutual funds use them.

• Table of contents

• Side pocketing in mutual funds
• How side pocketing works in mutual funds
• Reasons for side pocketing
• Impact of side pocketing on NAV
• Importance and benefits of side pocketing
• Potential drawbacks of side pocketing for investors
• Suitable duration for side pocketing
• Winding up of side pockets

Side pocketing in mutual funds

Side pocketing refers to the separation of select debt securities of a mutual fund scheme into a different account called a side pocket. Essentially, it’s like segregating a portfolio into two parts – the main fund and the side pocket. Typically, distressed assets or those that have been downgraded or pose a risk of default are transferred into side pockets. The objective is to isolate such securities, so that their valuations or illiquidity do not adversely impact the performance and liquidity of the main portfolio.

Side pockets help segregate assets that cannot be liquidated immediately without making a loss but have the potential to recover over time. Enabling their segregation protects the interests of investors in the scheme as it prevents them from booking losses by selling their investments in a panic.

Thus, side pocketing limits or contains the potential damage to the Net Asset Value (NAV) and redemption ability of the fund during times of market turmoil. Additionally, it helps an existing investor benefit if the distressed asset or defaulter later repays their loan.

How side pocketing works in mutual funds

When a debt security mutual fund scheme turns illiquid or faces default, payment delays, or credit rating downgrades, the fund manager can isolate it by transferring it into a newly created side pocket account.

The troubled assets are identified and removed from the main portfolio of the scheme. Existing investors in the fund are allotted side pocket units, representing the portion of their holding that has been segregated. for example, if an investor holds 1,000 units of a scheme with a NAV of Rs. 20, and 10% of assets are side pocketed, they will get 100 side pocket units.

Only investors who are unit holders on the date assets are transferred into the side pocket are eligible for side pocket units. If an investor redeems their main portfolio units, they still retain the side pocket units until that specific segregated portfolio is dissolved. Future investors entering the scheme after side pocket creation do not get any side pocket units.

The valuation and accounting of the side pocketed assets is done independently without impacting the NAV or redemptions of the main portfolio. Based on recovery of dues, resolution, or sale of the segregated assets, their proceeds are distributed proportionately to investors holding side pocket units. After the orderly winding down of the side pocket, investors realise the final net asset value of those holdings.

Reasons for side pocketing

• Marked downgrades in credit rating of debt instruments
• Default or delays in coupon payments by bond issuers
• Liquidity issues in traded securities leading to trading freezes
• Discovery of corporate fraud or governance issues
• Market manipulation triggering regulatory halts in trading
• Judicial stays stalling the sale of disputed assets
• Political instability, wars, or natural disasters freezing markets

In general, the common thread is the severely limited ability to determine fair value or liquidate the impacted asset. This necessitates segregation to prevent investors from booking losses on redemptions because of panicked reactions to negative news.

Impact of side pocketing on NAV

When assets from the main portfolio are transferred into a side pocket, there is a one-time impact on the Net Asset Value. For instance, if 5% of assets are side pocketed, the NAV falls by 5%.

However, subsequently, the NAV of the main fund is not impacted by the market value of the side-pocketed assets. The troubled assets are simply separated into a different account for valuation. Future ups and downs in their valuation will not affect the NAV of the main scheme portfolio. The ultimate recovery or loss of the side-pocketed securities will only be reflected once the side pocket is dissolved.

However, there may be an indirect psychological impact on the market price and investor perceptions. News about side pocketing may create uncertainty leading to short term NAV volatility.

Importance and benefits of side pocketing

• Isolates illiquid assets
• Avoids large-scale investor redemptions from the scheme
• Stops further impact to NAV of main portfolio
• Gives time to recover value of distressed assets through orderly exits
• Encourages investor trust in the fund house
• Treats investors fairly by segregating poorer performing holdings and spreading the impact of the illiquid assets among all existing investors.
• Maintains liquidity of the main portfolio for routine transactions
• Holds errant company management accountable
• Allows more flexibility to resolve stressed corporate loans/bonds
• Restructuring of defaulted debt without hurting other investors

Potential drawbacks of side pocketing for investors

• Forces investor lock-in until side pockets dissolved
• Limits full exit option compared to other assets
• Freezes capital in uncertain investments
• Carries risk of loss if issues unresolved
• Delays capital gains realisation for beneficiaries
• Hampers investor ability to switch out of troubled funds

Suitable duration for side pocketing

The suitable duration for side pocketing depends on the nature of the illiquid assets, regulatory requirements, and the fund’s objectives. Here’s a general breakdown:

Asset maturity and liquidity:

• If the side-pocketed assets are distressed or awaiting resolution (e.g., insolvency cases, lawsuits), the duration may be several years.
• If they are temporarily illiquid, the duration might be a few months to a couple of years until the asset becomes tradable again.

Regulatory framework:

• In some countries, regulators may impose guidelines on side-pocketing duration.
• Some funds require periodic reviews to determine whether the assets should remain side-pocketed or be written off.

Fund policies and investor communication:

• Clear communication with investors is mandated about the creation of the side pocket. Adequate disclosure of the side pocket is required in all scheme documents and the monthly portfolio disclosure.

Winding up of side pockets

Side pockets are not meant to be permanent constructs. As per regulations, fund houses have to periodically disclose and justify why specific side pockets remain open.

When favourable business developments allow the orderly sale of side pocketed assets, fund managers can monetise them. If legal resolutions aid recoveries, the proceeds can be distributed to investors in proportion to their side pocket units.

Upon full dissolution, the final NAV of the segregated assets can be paid out to side pocket unit holders. If a loss is ultimately incurred, it is absorbed by the beneficiaries who were holding the assets at the time of segregation. But the main scheme portfolio remains protected.

In short, side pockets provide a mechanism for mutual funds to handle troubled assets with fairness and contain the losses created by them. With knowledge of their workings, investors can assess how fund managers seek to tackle tricky situations.

Conclusion

Side pocketing is a facility used by mutual funds to separate illiquid, untradeable, or distressed assets to ringfence their impact on fund performance and liquidity. Careful usage of side pockets enhances the fund manager's ability to nurse unstable investments back to health through an orderly process. Investors benefit as their capital is shielded from the full brunt of mark-to-market losses. But side pockets should not become permanent parking lots for bad assets. Timely dissolution as per regulatory norms is key. Investors must keep a watch that fund houses use side pockets judiciously and not as an excuse to sweep problems under the carpet indefinitely.

FAQs:

What is side pocketing?

Side pocketing refers to the practice of segregating certain assets of a mutual fund into a separate account called a side pocket. Typically illiquid, untradeable or distressed assets are transferred into side pockets.

What is side pocketing in mutual funds?

Mutual funds use side pocketing to isolate problematic assets whose valuations or illiquidity may adversely affect the fund performance if retained in the main portfolio.

What are side pockets for?

Side pockets help ringfence assets facing troubles like market freezes. It gives fund houses time to nurse the assets back to health through orderly exits to optimise the potential for capital recovery.

What are side pockets called?

Side pockets are also referred to as segregated portfolios or bad asset pools at times.

What is side pocket realization?

Side pocket realization refers to the final proceeds distributed to investors when a mutual fund liquidates the segregated assets in a side pocket account.

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.