What Is Side-Pocketing in Mutual Funds and How Does It Work?

Mutual funds are market-linked products that offer the potential for higher returns compared to traditional modes of investment. However, with high potential returns come high risks.

Mutual funds that invest in corporate bonds are vulnerable to considerable losses if those companies become bankrupt and default on their debt obligations. Since the Infrastructure Leasing & Financial Services (IL&FS) crisis in September 2018, investors have become more careful about their investments. Hence, side-pocketing or segregated portfolio creation has been introduced in India to mitigate such risks.

This blog will learn more about side-pocketing and its numerous benefits.

What Is Side-Pocketing in Mutual Funds?

Compared to equity mutual funds, debt mutual funds are safer to invest in. This is because their portfolios include low-risk financial instruments such as government bonds, corporate bonds, treasury bills, etc. Even though they are considered stable investments, they are still subject to credit risks.

Side-Pocketing is an accounting technique used in debt mutual funds to segregate the bad assets within the fund. Assets that are illiquid, risky, and difficult to value are considered bad assets. 

Side-pocketing protects debt funds from illiquid assets negatively affecting their portfolios, which protects investors’ interests. The Securities and Exchange Board in India (SEBI ) has allowed AMCs to offer this facility since December 2018. 

When an asset enters the side pocket of a mutual fund, it becomes available only to investors who have already invested in it. The assets of side pockets are not available to future investors.

The advantage here is that when a side-pocket is created, the NAV of the mutual fund reflects only the main portfolio value and does not include the value of the side pocket which adversely affects the NAV of the mutual fund. But will this be a method used by Fund Managers to hide bad investment decisions? It is unlikely and this article will shed further light on why.  

What Is the Working Process of Side-Pocketing?

One needs to understand how side-pocketing works before investing in a debt fund. The process of side-pocketing includes separating a debt fund’s portfolio into two parts: One, which consists of reliable assets, and another, which consists of illiquid assets.

Illiquid assets consist of real estate, low-trade volume stocks, private equities, OTC (over-the-counter) stocks, etc. Assets that suffer from an adverse credit event are also included in this category.

A fund manager can segregate assets into a side pocket for numerous reasons. For instance, when an asset in the fund’s portfolio falls below the investment grade standards set by credit rating agencies such as CRISIL, it is put in the side pocket. This is done to protect the NAV of the main portfolio (Net Asset Value) and maintain its liquidity.

For instance, let us consider an investor holding 10,000 units of a mutual fund with a NAV of Rs. 10. Hence, the investor’s portfolio has a value of Rs. 1,00,000.

One of the assets contributes Rs. 2 to the NAV of the fund. Let’s say it downgrades to Rs. 1. The value of the investor’s portfolio would drop to Rs. 90,000.

The AMC would segregate the distressed asset to the side pocket so that the main portfolio’s NAV is unaffected. Although the value of the investor’s portfolio would remain the same at Rs. 90,000, the main portfolio would remain unaffected by the losses.

Why Is Side-Pocketing Needed?

SEBI guidelines require AMCs to adjust their debt portfolios in case of a drop in the credit ratings of one or more assets. However, these assets’ value may improve in the future. Therefore, side-pocketing is required so that investors can redeem units in the separated fund when its NAV improves while keeping the main portfolio’s assets liquid.

For instance, let us consider that a mutual debt fund was valued at Rs. 500 crores. A situation may arise where a company owning 10% of the fund’s assets goes bankrupt. In this case, the company will default, and the fund’s value will fall to Rs. 450 crores.

Seeing this, investors start redeeming their fund units to avoid further losses. However, this would cause the illiquid assets to remain in the fund, and the percentage of bad assets would increase. This would, in turn, negatively affect investors’ returns.

To avoid such a situation, AMCs segregate distressed assets into a side pocket so that the main portfolio remains unaffected, stabilising this fund’s NAV. While some investors will likely exit their investments from the distressed portfolio, others may hold on.

If this segregated fund improves, its unitholders get the right to benefit from its growth. In the above example, investors who remain invested in the side pocket will benefit from its recovery.

What Are the Advantages of Side-Pocketing in Mutual Funds?

Side-Pocketing comes with several advantages for both AMCs and investors. The following are some of the benefits of this facility:

• Side-pockets help investors stay invested in risky assets without affecting the liquidity of the main portfolio. When assets in the side pocket improve in credit rating and generate returns, they are distributed among investors.
• Before this method was available, many investors were forced to exit funds with downgraded assets. Side-Pocketing allows investors to stay invested and retain trust in a fund.
• It prevents investors from making bad investments.
• Side-pocketing in mutual funds ensures that profits are equal. It removes situations where investors who exit early can get a higher value of profits.
• The framework is set up so new investors cannot take undue advantage of segregated portfolios.

Meanwhile, AMCs and fund managers get the following benefits from side-pocketing:

• Firstly, side-pocketing eliminates the need for investors to exit due to credit events. This would lead to massive redemption requests, and fund managers had to sell off healthy assets to fulfil such requests. However, this has become a rare scenario after the introduction of side pockets.
• Since side-pocketing reduces redemptions, fund managers can focus on recovering investments from illiquid financial instruments.

What Are the Disadvantages of Side-Pocketing?

The side-pocketing technique also comes with several disadvantages. Some of these are:

• Side-pocketing may result in a lack of trust between the fund manager and investors. 
• Some fund managers may misuse it to cover up bad investment decisions.
• Since the valuation of illiquid assets is complex, the actual value of the segregated fund can be hard to calculate.
• Keeping track of both the main and segregated portfolios can be difficult for investors.
• Fund units in the side pocket stay frozen. Investors cannot freely redeem the units in the side pocket. Instead, they have to wait until the recovery of their investment.

Is Side-Pocketing Compulsory?

SEBI has not made side-pocketing mandatory. The decision to create side pockets remains in the hands of AMCs. Numerous AMCs have implemented the side-pocketing technique in their debt and hybrid fund schemes. 

This has been done to protect the interests of the investors and help recover their profits in the future. This would protect them in case of a credit event that negatively impacts the NAV of the mutual fund.

Regulation of Side-Pocketing

SEBI (Securities Exchange Board of India) has checks and balances to curtail the misuse of side-pocketing. SEBI has asked the administrators of AMCs to implement a framework that would have a negative effect on the incentives of fund managers upon using side pocketing.

Since creating side pockets would affect their performance incentives, it discourages fund managers from misusing this facility to camouflage bad investment decisions. In addition, the misuse of side-pocketing would result in strict action taken by SEBI.

Taxation of a Segregated Portfolio

When investors redeem their units in debt funds within three years of holding, they are subject to STCG (short-term capital gains) tax rates. The tax rate applicable to STCG is the same as the investor’s income tax slab.

When an investor redeems their units after a holding period of three years, they make long-term capital gains. In the case of LTCG, they are taxed at a rate of 20% after indexation, along with cess and tax surcharge.

As per the Union Budget 2020, the holding time for NAV units in a segregated portfolio will be counted from the original investment date for tax purposes. For instance, if an investor purchases fund units on April 30, 2016, and the portfolio segregation occurs on April 30 2020, the holding time will be calculated from April 30, 2016. 

Also, the investment cost will be assigned between the main portfolio and side pocket in the same ratio as the main portfolio and side pocket before the next credit event.

Final Word

Side-pocketing is one of the best accounting methods AMCs use to safeguard investors’ interests in mutual funds. Its main benefit is that it stops investors from redeeming their investments in a panic. As its popularity grows, many AMCs and fund managers are adopting this technique in their funds.

Side pocketing helps in the smooth functioning of a fund and helps retain investors’ confidence during a credit event.

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