What is Side-Pocketing in Mutual Funds? Process, Triggers & Impact

Understanding Side-Pocketing in Mutual Funds

Side-pocketing is an accounting process where a mutual fund separates its distressed or low-quality debt securities from the main portfolio. This creates two distinct portfolios:

    • A main portfolio that contains healthy and liquid assets.
    • A side pocket that holds the troubled or illiquid assets.

The idea is straightforward — when a company in which the fund has invested fails to pay its dues or is downgraded, that portion of the fund is moved to a separate pocket. This protects the value of the main portfolio and keeps investors’ healthy investments safe from further impact.

In other words, side-pocketing ensures that when bad news hits one part of the fund, it doesn’t pull everything else down with it.

Why Was Side-Pocketing Introduced?

The idea of side-pocketing became popular in India after the IL&FS crisis in 2018. Many mutual funds had put money into IL&FS, but the company failed to pay back its debts. This made those investments almost worthless and caused panic among investors. When one company failed, it pulled down the value of the whole fund.

To fix this problem, the Securities and Exchange Board of India (SEBI) allowed mutual funds to create side pockets for risky investments. This rule helps protect investors and keeps things clear and fair when the market faces trouble.

How Side-Pocketing Works

Side-pocketing starts when a credit event occurs. A credit event can be a default, delay in payment, or a downgrade of a company’s debt rating to below investment grade. Once this happens, the mutual fund takes the following steps:

Once the side pocket is created, no new purchases or redemptions are allowed in it. However, if any recovery happens later, the benefit goes only to the investors who held the units when the segregation took place.

When Can Side-Pocketing Be Triggered?

A mutual fund can create a side pocket only after a credit event. The trigger is typically one of the following situations:

    • A downgrade of a debt instrument to below investment grade.
    • A default in interest or principal payment by the issuer.
    • A delay or suspension of payments leading to credit uncertainty.

The process must be completed within a specific timeframe, and the trustee’s approval is mandatory. This ensures that fund houses use side-pocketing only when necessary and not as a tool to hide poor investment choices.

How Side-Pocketing Protects Investors

Side-pocketing has many benefits for both investors and fund managers.

1. Stops Panic Withdrawals

When a company fails to pay back its debt, many people try to pull their money out of the fund at once. This can make the fund sell its good investments at a loss. Side-pocketing separates the bad part, helping investors stay calm and avoid rushing to withdraw.

2. Keeps Things Fair

Without side-pocketing, new investors could join a fund at a cheaper price and later enjoy the profits when things improve. Side-pocketing makes sure that only the people who faced the loss get the benefit if the money is recovered later.

3. Keeps the Value Steady

By moving the risky assets aside, the main part of the fund stays steady and shows the real value of the healthy investments.

4. Helps in Recovery

Fund managers can focus on fixing or recovering the bad investments in the side pocket without worrying about hurting the rest of the fund.

Limitations of Side-Pocketing

Although useful, side-pocketing comes with certain drawbacks that investors must understand.

1. Illiquidity

Side-pocketed units cannot be redeemed until recovery happens. This means a portion of your investment may remain blocked for months or even years.

2. Valuation Challenges

It is difficult to accurately value distressed assets. Their market worth may fluctuate or remain uncertain for long periods.

3. Operational Complexity

Managing two NAVs and maintaining separate records increases the administrative burden for fund houses.

4. Risk of Misuse

If not properly monitored, fund managers might use side-pocketing to mask poor investment decisions. This is why SEBI’s oversight and disclosure requirements are critical.

Tax Implications for Investors

The tax rules for side-pocketed units are the same as the rules for your original investment. The time you’ve held the investment is counted from the day you first bought it, not from the day the side pocket was made.

The cost of your investment is divided between the main fund and the side pocket based on their values right before they were separated. This method keeps things fair and simple when working out how much profit or gain you’ve made.

Impact on Mutual Funds and Investors

Side-pocketing has made debt mutual funds easier to understand and stronger. It helps fund managers handle risky loans or bonds in a smarter way and keeps investors’ money safer when the market faces problems.

For investors, it gives clarity and confidence. They can clearly see which part of their money is affected and know that if any of it is recovered later, it will come back to them. For fund managers, it’s a simple system that lets them deal with defaults without upsetting the whole fund.

But it’s important to remember that side-pocketing doesn’t remove all risk. It only helps limit the damage when something goes wrong. The best protection is still to choose funds that manage risk well and invest in many different places instead of just one.

Conclusion

Side-pocketing in mutual funds is a smart way to handle money when something unexpected happens — like when a company cannot pay back what it owes. It works by separating risky investments from safe ones, so that one bad decision doesn’t hurt the whole fund.

For investors, knowing how side-pocketing works is useful. It helps them stay calm when the market is shaky. The idea might sound boring, but it’s actually very important. It helps people trust mutual funds and keeps their money more stable during tough times.

In short, side-pocketing is like a safety net. It protects your investments when things go wrong and keeps them steady until things get better.