Side Pocketing in Mutual Funds

A technique known as side pocketing is employed to protect investors in instruments that have exposure to risky assets; this is essentially an accounting procedure that segregates illiquid investments from liquid and high-quality investments in a debt portfolio.

Below is the example to understand clearly:

Imagine you have Rs 1,00,000 rupees invested in a credit risk fund and the total AUM of the fund is Rs 1 Cr, and one fine morning you see the news to find that one of the papers (which is 10% in your debt portfolio) has been downgraded and might also get a default stamp

Furthermore, a major investor redeemed his entire portfolio worth 40 lakhs

Feel you are being treated unfairly here, don't you?

Okay, let me do some math to help you assess the situation realistically.

Total AUM of the Fund = Rs 1 Cr

Your Investment= Rs 1,00,000 i.e. 1% of the total portfolio

Bad Assets in the Portfolio = 10%

Your Proportional Investment in the Bad assets = 1, 00,000*10% = Rs 10,000

Since one of the major Investor has withdrawn his entire portfolio worth Rs 40,00,000, the calculations will change dynamically

New Total AUM of the Fund = Rs 60,00,000

Your Investment = Rs 1,00,000

Bad Assets in the portfolio = 10,00,000/60, 00,000= 16.66%

Your New Proportional Investment in the Bad Assets = 1,00,000*16.66% = 16,666

Net Increase in the Proportional Investment in the Bad Assets = 16,666-10,000= Rs 6,666

Now you have a better understanding of how beautifully you were trapped.

Since a large institutional investor redeemed his entire portfolio, a retail investor got a greater share of the bad portfolio. A bad portfolio consists of holdings that have been downgraded and are at risk of default that is highly illiquid. The solution is Side Pocketing, which shields investors from such exploitative conditions.

In a nutshell, side pocketing is the separation of "Bad Assets" from the rest of the portfolio. When any security is downgraded in a portfolio, it moves to the side pocket, where previous investors receive a pro-rata portion. A new NAV is also allocated to the problematic assets based on their realizable worth. Although, It might be challenging for the existing investors to track two NAVs.

The Mechanics of Side Pocketing is strategically manufactured in the Investors' Interest whether it’s existing or new since only current investors will be eligible to recoup from defective assets that are segregated and fresh investment capital from new investors will be added to the original portfolio, which is no longer comprised of substandard assets.

Side-pocketing was demanded for the first time in India in 2015 when JPMorgan MF's exposure to Amtek Auto bonds was unexpectedly graded below investment grade due to insufficient information and/or chronic liquidity difficulties. Despite the protests of the Indian mutual fund sector, SEBI did not take a lenient stance on the practice.

When a debt or money market instrument is downgraded to "below investment grade" or receives any subsequent downgrades, this constitutes a "credit event" at the issuer level, and SEBI has granted the Asset Management Company (AMC) permission to segregate assets according to a circular issued on December 28, 2018 (Circular).