Side Pocketing: Types, Importance & Drawbacks

Debt mutual funds are subject to various market risks. However, the side pocket is one such feature you should know about if you're investing in debt mutual funds. Read further to know more about it.

Debt mutual funds or fixed-income funds usually consist of corporate bonds, government securities, debentures and money market instruments. These types of mutual funds are considered as the most stable type of investments as they help to grow wealth in the long run. Debt funds are less risky as compared to equity funds, but they do not guarantee returns as they are subject to market risks. This type of fund is best suitable for you if you can bear the moderate risk and in case you have a surplus fund.

Below are some of the types of debt funds you can invest in:

• Liquid funds

• Short/ Medium/long-term funds

• Dynamic Bond Funds

• Fixed Maturity Plans

As an experienced investor, you are well-versed with the fact that debt fund carry various types of risks – credit risk, interest risk, reinvestment risk, inflation risk, etc. Many rating agencies like CRISIL, CARE, etc. provide "Credit Ratings."

When it comes to risks, fund managers are most importantly concerned about the possible downgrading in the credit rating of a debt paper. For instance, if a debt paper gets downgraded, the market value of the paper decreases, which in turn affects the overall portfolio.

To ensure that investors are not affected by the downgrading, fund managers can start the process of side-pocketing. This process was launched by the Securities and Exchange Board of India (SEBI), wherein a fund manager creates a separate portfolio of troubled or distressed assets so that your liquidity is not affected. The segregation of risky pockets helps to stabilize the net asset value (NAV) of a scheme and enables small investors to redeem the value from liquid assets eliminating the exit impact of illiquid assets.

Let's understand the importance of Side Pocketing in Mutual Funds

• Without side-pocketing, mutual fund managers will be able to issue less than a fair share of the fund value.

• The side-pocketing will freeze the entire fund that could cause a large disruption

• Side-pocketing in mutual funds ensures that profits are equal, it eliminates cases wherein those who get out of the fund may get higher effective value

• It eliminates new investors to take undue advantages after the side-pocketing takes place

Suppose a fund scheme has Rs,1000 crore in a corpus, out of which Rs. 50 crore debt fund is held by a company which is defaulting in its securities. In such a situation, the fund manager chooses to redeem the complete investment portfolio.

The redemption process compels fund managers to sell liquid assets to large investors, affecting the retail investors.

The fund manager will execute side pocketing, wherein it will separate Rs. 50 crores from the remaining corpus of Rs. 950 crores. Based on this, investors will be provided with units under new allocation.

• The process may ignore specific components, primarily the illiquid that are added in side-pocket

• Another disadvantage is the inexperience of holding illiquid funds by novice fund managers. These fund managers may also fail to create net asset value of the fund for medium or long-term

• Side pocket may give rise to trust issues between the investors and fund managers

To control the misuse of side pocketing in mutual funds, SEBI has put in place certain checks and balances. It has asked asset management companies to create a framework that will impact the earnings of the fund managers who issue side pocketing in mutual funds, thereby affecting the investors' returns. SEBI will take stringent action if there is any misuse of the side pocket by fund managers, chief investment officers, etc.