Side Pocketing in Mutual Funds Explained: SEBI Rules, Pros & Cons

A lot of investors look at debt mutual funds as a completely safe bet these days. But let’s be real, the risk of credit default never truly goes away. If a company that issued a bond starts struggling financially, the hit is felt by the fund too. That’s exactly where side pocketing in mutual funds comes in as a lifesaver to protect your hard-earned money. In this article, we’ll break down in plain English what side pocketing actually means, how it operates, the pros and cons, and what SEBI has to say about it.

What Is Side Pocketing in Mutual Funds? 

Essentially, side pocketing in mutual funds is a process wherein a distressed or defaulting debt security (such as a bond or debenture) held in a debt mutual fund’s portfolio is separated from the rest of the investments. This measure is taken when there is a significant downgrade in the security’s credit rating or an increased risk of default. This prevents an undue impact on the value of the remaining portfolio and ensures fair treatment for existing investors.

Meaning of Side Pocketing

In simple terms, side pocketing involves a mutual fund segregating its risky assets. Consequently, the fund splits into two parts: a ‘Main Portfolio’ containing standard investments, and a ‘Segregated Portfolio’ holding only the distressed security. Investors receive units for both portfolios, but new investments are accepted only into the Main Portfolio.

How Does Side Pocketing in Mutual Funds Work? 

Side pocketing in mutual funds applies only when a serious credit event such as a default or a significant downgrade in credit rating occurs with a debt security. The fund house then segregates the affected security from the rest of the portfolio, allowing the performance of the healthy investments to continue independently.

Phase	What happens?
A credit event occurs.	The credit rating of a bond or debt security suddenly drops, or it defaults.
The AMC makes the decision.	The Asset Management Company decides to implement side-pocketing in accordance with SEBI regulations.
The portfolio is separated.	The affected debt security is removed from the main portfolio and placed in a segregated portfolio.
Units are divided.	On the day side-pocketing is implemented, existing investors receive units of both portfolios.
The main portfolio operates normally.	All other high-quality investments continue to be managed as before, and their NAV is updated separately.
Payment is received upon recovery.	If any amount is recovered in the future from a defaulted security, the benefit is extended only to the investors eligible at that time.

Example: Suppose a bond worth ₹8 crore defaults within a debt mutual fund’s total portfolio of ₹100 crore. In such a scenario, the defaulted bond (worth ₹8 crore) is moved to a separate ‘segregated portfolio,’ while the remaining investment of ₹92 crore stays in the ‘main portfolio.’ This allows the NAV of the healthy investments to continue independently; furthermore, if any recovery is subsequently made from the defaulted bond, the benefit accrues solely to the investors holding units at that time.

Why Mutual Funds Introduce Side Pocketing 

The objective of side pocketing is to ensure fair treatment of investors during a credit event and to enhance fund transparency.

• Protects Existing Investors: When the value of a debt security drops suddenly, side pocketing segregates it. This safeguards the interests of existing investors and prevents new investors from taking unfair advantage of the situation.
• Prevents Panic Redemptions: If a distressed asset is not segregated, many investors might panic and redeem their units immediately. Side pocketing helps manage this situation and ensures equitable treatment for all investors.
• Ensures Fair Valuation: Once the distressed security is segregated, the Net Asset Value (NAV) of the main portfolio is determined based on its actual value. This keeps the fund’s valuation more transparent and accurate.
• Improves Portfolio Management: When a risky security is segregated, the fund manager can focus more effectively on healthy investments. Additionally, it becomes easier to separately manage the recovery process for the affected asset.

SEBI Rules for Side Pocketing in Mutual Funds 

SEBI has formulated clear rules for side-pocketing to ensure it is used only in the event of a genuine credit event and that investors’ interests remain protected.

SEBI Rule	What does it mean?
Applicable only to Credit Events.	Side pocketing can be initiated only when the credit rating of a debt or money market instrument falls below investment grade or undergoes a further downgrade.
Decision at the AMC’s discretion	Creating a side pocket is not mandatory. The decision rests with the concerned Asset Management Company (AMC), but it must adhere to SEBI regulations and scheme documents.
Provisions in scheme documents are essential.	Side-pocketing in a mutual fund scheme can be undertaken only if it has been previously authorized in the Scheme Information Document (SID) and the Statement of Additional Information (SAI).
Only existing investors benefit	Only those investors who hold units at the time of side-pocketing are entitled to the segregated portfolio; investors who invest subsequently do not have this right.
Separate NAV for Main Portfolio and Segregated Portfolio	After side-pocketing, the NAV for both portfolios is calculated and published separately to ensure accurate valuation.
Trustee Approval and Disclosure	Following a credit event, the AMC is required to obtain the Trustee’s approval and inform investors through press releases, the website, and other channels.

Read Also: Best Books on Mutual Funds for Beginners in India

Which Mutual Funds Can Use Side Pocketing? 

Side pocketing is primarily used in mutual funds that invest in debt securities where there is a possibility of credit risk.

• Credit Risk Funds: These funds invest in bonds with relatively lower credit ratings; therefore, the likelihood of side pocketing is higher in these funds.
• Corporate Bond Funds: If a credit event occurs regarding a corporate bond, side pocketing can be implemented if necessary.
• Banking & PSU Debt Funds: These funds invest in debt instruments issued by banks and PSUs. Side pocketing may be utilized in the rare event of a credit event.
• Short Duration & Dynamic Bond Funds: If a severe credit event occurs involving a debt security held in their portfolios, side pocketing can be implemented in accordance with SEBI regulations.

Side Pocketing vs Normal Mutual Fund Portfolio 

Parameter	Normal Mutual Fund Portfolio	Side Pocketed Portfolio
Portfolio Structure	Best Books on Mutual Funds for Beginners in India	It is divided into a Main Portfolio and a Segregated Portfolio.
NAV	There is only one NAV.	Both portfolios have separate NAVs.
Risky Security	All securities are held together.	Risky securities are segregated.
Investor Eligibility	All investors can invest or redeem in accordance with the standard rules.	Only the investors present at the time of side-pocketing receive units of the segregated portfolio.
Recovery	There is no separate recovery process.	Eligible investors are provided benefits upon recovery from the affected security.
Purpose	Management of general investments.	Protection of investors’ interests and fair valuation during a credit event.

Benefits of Side Pocketing in Mutual Funds 

Side pocketing in mutual funds plays a crucial role in protecting investor interests while maintaining the fund’s transparency and fairness.

• Fair Treatment for Investors: When a credit event occurs involving a debt security, side pocketing ensures that all investors present at that time are treated equally. This prevents any investor from gaining an unfair advantage by entering or exiting the fund hastily.
• Better Transparency: Once side pocketing is implemented, the main portfolio and the segregated portfolio are displayed separately. This allows investors to clearly distinguish between standard investments and securities affected by credit risk.
• Accurate NAV Calculation: The risky security that has been segregated does not impact the NAV of the main portfolio. Consequently, the fund’s value reflects a more accurate picture based on the remaining investments.
• Easier Recovery Process: If any amount is recovered in the future from the defaulted debt security, it is distributed only to the eligible investors. This makes the entire recovery process more organized and transparent.
• Better Portfolio Management: By segregating the risky asset, the fund manager can manage the healthy portfolio more effectively. This allows the remaining investments to continue functioning normally without their performance being unduly affected.

Risks and Limitations of Side Pocketing 

Side pocketing in mutual funds is a safety net for investors, but it’s not a panacea for every problem. Some investment risks persist.

• Recovery Is Not Guaranteed: If a defaulted debt security fails to recover in the future, investments held in a segregated portfolio may result in a full or partial loss.
• Money Can Remain Locked: The funds held in a segregated portfolio are not available until the security is recovered or finally resolved. Therefore, investors may have to wait.
• Value May Continue to Decline: If the financial condition of the affected company worsens, the value of the segregated portfolio may decline further.
• Not Applicable in Every Situation: Side pocketing is only applicable in the event of a serious credit event, such as a default or a major credit rating downgrade. It is not applicable in all market fluctuations.
• Doesn’t Eliminate Investment Risk: Side pocketing certainly buffers losses, but it doesn’t completely eliminate investment risk. Therefore, it’s always important to understand a debt mutual fund’s credit quality and portfolio holdings when choosing a debt mutual fund.

Read Also: What is TREPS & Why Mutual Funds Invest in it?

Conclusion

Side-pocketing in mutual funds is a crucial provision designed to protect investors’ interests, particularly when a credit event occurs involving a debt security. While it does not entirely prevent losses, it helps maintain the fund’s transparency and fairness. Therefore, it is advisable to make an informed decision by understanding the credit quality, portfolio, and risk profile before investing in any debt mutual fund.

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