Side Pocketing in Mutual Funds: A Complete Investors Guide

19 December, 2024

Synopsis

• Side pocketing is an accounting technique used in mutual funds to separate risky assets from healthier ones.
• It was introduced by SEBI in 2018 after the IL&FS crisis to protect investors from sudden drops in fund value.
• The process involves creating a separate portfolio for troubled assets, isolating them from the main fund.
• Side pocketing helps mitigate risk and maintain investor confidence in mutual funds.
  
  

Imagine you are travelling to a new city carrying some cash, cards and important documents. Your instinct might prompt you to split these valuables—some go in your backpack, while others are tucked in a hidden pouch. Why? Because if one pouch gets lost or stolen, you still have the other to rely on. This simple idea of risk management isn’t just for travellers—it’s a concept that’s also applied in the financial world through a technique called Side Pocketing in mutual funds.

In investments, particularly in mutual funds, side pocketing acts like your hidden pouch. It’s a way to separate risky, less liquid investments from safer ones, so if one part goes away, your main investments remain secure. But how exactly does it work? And why should you care? Let’s understand side pocketing in mutual funds, its benefits, limitations, and how it impacts you as an investor.

What is Side Pocketing in Mutual Funds?

Side-pocketing is an accounting technique used by mutual funds to separate distressed or bad assets from healthier ones. This distinction ensures that risky assets do not affect the value of the entire portfolio. When a fund manager identifies assets that have become illiquid or too risky, these are moved to a "side pocket." The remaining safer assets continue to operate as usual, allowing a clearer view of the fund’s performance.

Why Side Pocketing Was Introduced?

SEBI formally introduced the concept of side-pocketing for debt mutual funds in December 2018 after the Infrastructure Leasing & Financial Services (IL&FS) crisis rattled the market. Many debt funds held investments in IL&FS, which became non-performing assets overnight. This led to massive panic among investors and a loss of confidence in debt funds. To prevent such situations from spilling over into entire portfolios, SEBI approved side pockets, allowing fund managers to isolate risky assets from the main fund.

Benefits of Side Pocketing

1. Risk Mitigation
   Side pocketing helps safeguard the value of the main portfolio when bad assets are identified. Investors are insulated from a sudden drop in NAV (Net Asset Value) due to these risky assets.
   
   

2. Investor Confidence
   Knowing that bad assets won’t taint the entire fund, investors remain more confident in their mutual fund investments.
   
   

3. Fair Play for Existing Investors
   Side pockets prevent a situation where new investors buy into a fund at a lower NAV due to troubled assets, thereby safeguarding the interests of long-term investors.
   
   

4. One-time Loss Recognition
   Instead of waiting for a bad asset to impact the fund repeatedly, side pocketing recognizes a one-time loss, making the NAV of the main portfolio more transparent.
   
   

Drawbacks of Side Pocketing

1. Opaque Valuation of Side Pockets
   Determining the true value of a side-pocketed asset can be complex and uncertain, leading to confusion about its real worth.
   
   

2. Investor Frustration
   Since side-pocketed assets are illiquid, investors may have to wait indefinitely before they can redeem their money.
   
   

3. Trust Issues with Fund Managers
   Some fund managers might misuse side pocketing to cover up poor investment decisions, eroding investor trust.
   
   

4. Operational Challenges
   Managing two sets of funds—main and side pockets—adds operational complexity for fund managers.
   
   

Side pocketing is like having a spare tyre in your car. You hope you never need it, but it’s comforting to know that it’s there to protect you from getting completely stranded. As an investor, understanding how side pocketing works can help you make informed decisions, especially when investing in mutual funds in debt. While it has its drawbacks, the technique provides a safety net during turbulent times, ensuring that one bad investment doesn’t sink your entire ship.

Keep your investments on course even during turbulent times. Explore how concepts like side pocketing safeguard your funds—download the HDFC Bank SmartWealth App from Playstore/Appstore to manage and monitor your mutual fund investments effectively.

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