How side pocketing works in debt mutual funds

Side pocketing is considered as a change in the fundamental attributes of a scheme.

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Some fund houses have incorporated side pocket option in their debt schemes, which allows bad securities to be separated from the good ones.

What is a side pocket?
A ‘side pocket’ option allows a fund house to separate bad assets from other liquid investments in a debt portfolio which could get impacted by the credit profile of underlying instruments. This process is useful as it helps small investors from being hit by sudden exits of large investors. It helps stabilise the net asset value (NAV) and reduces redemptions in the scheme. If the illiquidity event is sudden, side pocketing provides a cushion to the liquid portfolio.

How is it done?
Side pocketing is considered as a change in the fundamental attributes of a scheme. This requires an asset management company (AMC) proposing to create a side pocket to amend the scheme information document (SID) and allow an exit window of 30 days without charging any exit load. Once this permission is taken on the day of the event, the AMC can segregate papers that are illiquid or in default category from all other instruments in the portfolio that are liquid. This creates two schemes — one that contains the illiquid paper and the other holding the good ones.

Why is this useful for investors?
A fixed income fund that has a corpus of Rs 1,000 crore with a 5 per cent exposure to a company that defaults. Due to this default by one company, many large investors tend to redeem their money from the scheme to avoid any further loss. To pay them, the scheme is forced to sell good paper, and thus the percentage holding of bad assets in the portfolio rises. By segregating the bad asset, investors do not rush in to redeem. As and when the affected company pays back, the investors will get their money back.

Is side pocket compulsory?
Sebi has not made side pocketing compulsory for all bonds that turn non-investment grade. This decision is left to the discretion of the AMC and its trustees. So, when a bond slips into non-investment grade, some AMCs may write down its value, while others may side pocket it.

Are there any disadvantages of side pocketing?
Side pocketing should be used with caution. Analysts point out that since valuations of the illiquid or defaulted asset is contentious, NAV of the illiquid asset will not be discoverable. Investors will often find it difficult to track two sets NAV. Finally, the fund house should not misuse side pockets to protect managers’ fees on the more liquid assets or to hide poorly performing assets or poor liquidity management by its fund managers.
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