What Is Side Pocketing in a Mutual Fund? Meaning, Rules, and Impact Explained

What will happen when your mutual fund portfolio has some illiquid funds? Well, in the normal scenario, the fund performance will tend to fall. This will be mainly due to the lack of any type of trading opportunities. And this is more common when there is market distress or some uncertainty. But is there any way to tackle it?

Well, there is one option which is known as the side pocketing. This is nothing but a method to separate the illiquid assets from the liquid ones to avoid the impact on NAV. But there is more to it than you should know.

So, if you are here to understand the side pocketing rule, then read this guide. Get answers to all your queries and ensure you manage your portfolio well.

Side Pocketing Meaning

Side pocketing refers to the process by which a mutual fund separates stressed, downgraded, or defaulted securities from its main portfolio. These troubled assets are moved into a separate account. This is known as the side pocket. The remaining healthy assets continue to be valued and traded normally.

In simple terms, side pocketing protects existing investors from unfair losses. But at the same time, the new investors cannot enter the fund. This is mainly to benefit from a possible recovery of the stressed asset. This can be used with all types of mutual funds. 

This practice ensures fair NAV calculation and transparency. In side pocketing in mutual funds, investors receive units in both the main portfolio and the side pocket.  Any recovery from the stressed asset is credited only to those who were invested at the time of the event.

How Side Pocketing Works in Mutual Funds

Side pocketing follows a clear and regulated process once a credit event occurs. It is aimed at securing the returns of the investors. By following this method, investors can avoid losses and ensure that their investment stays secure. In general, the steps followed are as follows:

Step 1: Credit Event Occurs

A bond or debt instrument is generally the point of concern in the fund. For better, these are the options that are downgraded to below investment grade or default. This triggers the need to follow the side pocketing rule.

Step 2: Asset Is Segregated

The stressed security is separated from the main portfolio. This is the security or the asset that is moved into a side pocket. The rest of the fund continues normally. It is important to note that this does not impact the AUM. 

Step 3: NAV Is Split

The fund now has two NAVs. One for the main portfolio. Then the other one is the side pocket holding the stressed asset. This way, the entire asset allocation of the fund is changed for efficient working. 

Step 4: Units Are Allotted

Existing investors receive proportional units in both portfolios. This is to ensure that they get the right value for their invested amount. New investors cannot access the side pocket.

Step 5: Recovery or Write-Off

If money is recovered later, it is paid only to investors who held units at the time of side pocketing. If there is no recovery, the side pocket may eventually be written off. This way, the entire value of potential losses is reduced to a great extent.

How Side Pocketing Impacts Investors

Side pocketing impacts investors in both positive and practical ways. The biggest impact is on fairness. Side pocketing in mutual funds protects existing investors. This is mainly needed from sudden dilution caused by new investors entering at a lower NAV.

For investors already holding the fund, the NAV is split. One part reflects healthy assets, while the other reflects the stressed security. This may look like an immediate drop in NAV, but it improves transparency. Investors can redeem only the main portfolio units. Side pocket units stay locked until recovery or write-off.

New investors cannot benefit from any future recovery of the stressed asset. Overall, side pocketing is about protecting the long-term investors.

Impact on NAV and Returns

Side pocketing has a direct impact on NAV. But this is not a direct sign of loss. When side pocketing in mutual funds is applied, the fund’s NAV is split into two parts. 

• One NAV represents the main portfolio with healthy securities. 

• The other NAV represents the side pocket holding the stressed or defaulted asset.

This will show a temporary fall in the value. However, the future performance of the main portfolio remains unaffected by the stressed asset. And even if there is a recovery, the returns are added later to those who took the risk.

Pros of Side Pocketing

• Side pocketing protects existing investors from unfair dilution.

• It improves transparency by clearly separating stressed assets.

• The plan prevents short-term investors from benefiting from future recovery.

• It allows the main portfolio to show a realistic NAV.

Cons of Side Pocketing

• Investors may see an immediate drop in NAV.

• Side pocket units cannot be redeemed until recovery or write-off.

• Returns from the stressed asset are uncertain.

• It can create confusion for new investors.

Conclusion

Side pocketing is a protective measure. It is used in debt mutual funds during credit stress. This protects investors from the risk and avoids the chances of high dilution. But understanding this is important when you plan on investing. And if you need expert support while doing the mutual fund investments, then register on Rupeezy today.

FAQs

What is side pocketing in mutual funds?

It is the separation of stressed or defaulted debt securities from the main fund portfolio to protect existing investors.

When is side pocketing applied?

It is applied after a credit downgrade below investment grade or a default, as per SEBI rules.

Can investors redeem side pocket units?

No, side pocket units stay locked until recovery or write-off.

Does side pocketing affect NAV?

Yes, NAV is split into two parts: the main portfolio and the side pocket.

Is side pocketing beneficial for investors?

Yes, it ensures fairness, transparency, and protects long-term investors.