How side pocketing works in mutual funds?

The IL&FS disaster is still fresh in our minds. It reflected the stressed entities of these big fund houses. This affects the net return of the fund houses, and this, in turn, can have an adverse impact on investor returns. It was basically this factor due to which The Securities and Exchange Board of India (SEBI) introduced the concept of side pocketing in debt mutual funds.

Understanding the concept of side pockets

To put it in simple words, it is separating the bad assets from the good assets. This is a framework that allows the fund houses to put the bad assets in a separate portfolio. This portfolio will be under debt schemes.

This process has many advantages. It will help in the stabilisation of the Net Asset Value (NAV). The sudden exit of the big investor will not have an impact on small investors.

The many benefits of side pocketing for investors

In side-pocketing, all the bad assets are being separated from the good assets. All the investors in the scheme will be given an equal number of units in the separated portfolio. Redemption is not allowed in this segregated portfolio.

Within the next 10 days, the units have to be listed in the stock exchange. The investors will have the opportunity to sell bad assets at the existing price. Or they can hold on to the assets if they feel that there are chances that the prices will improve in the future.

Here is how side pocketing is done!

In side-pocketing, the fundamental attributes of the scheme are being changed. An asset management company will give the proposal to change the Scheme Information Document that is SID and the creation of the side pocket. There will be an exit window of 30 days. Once the approval is obtained, then the asset management company will separate the bad assets from the other instruments in the portfolio. As a result, you will have 2 schemes. One that has the bad assets and one that has good assets.

Understanding side-pocketing made easy with an example

Let us assume that there is a fund house that has the corpus fund or capital of Rs 1000 crore. Out of these 50 crores has been held in a company that is a defaulter. In such cases, the investor will try to redeem his entire investment at the earliest. Due to this, the fund manager will be forced to sell good bonds to pay the investor. As a result, only bad assets will remain in the end. This will have an adverse impact on the small investor.

In such cases, side pocketing can be implemented. That is, the 50 crores will be separated from the 950 crores. The institutional and the retail investors will be provided with units as per the new allocation.

Is it mandatory to do side pocketing?

SEBI has not made side pocketing mandatory. It has given it as an option to the fund houses. The Asset management company and the trustees have to take a call if they want to make use of the side pocketing concept, or they want to write down the value of the bond when it goes into the non-investment grades.

A look at the pros and cons of side pocketing

Side pocketing has its own advantages as well as disadvantages.

To put it in a nutshell, side pocketing are investment accounts that are legal. But these accounts are monitored by regulatory bodies. These side pockets have risky and illiquid assets that have been separated from the other funds.

It must be noted that when an investment is put into a side pocket, then only the current investors can get a share of it. No new investors can be included in the same. The current investor will get a pro-rata investment in the side pocket account.

That’s why Comparte Investment team asks do you have “Nivesh Ki Aadat”.

With this one can say “Mutual Fund Sahi hai”,  so let me do Nivesh