What exactly is meant by mutual fund side-pocketing? How is it useful and are mutual funds doing this side pocketing?

The regulator introduced Side Pocketing as an option for mutual funds in the aftermath of many mutual funds delaying the redemption of their FMPs due to funds stuck in illiquid debt instruments. It was only after the crisis faced by debt funds holding bonds and CP of IL&FS and DHFL that the regulator decided to permit the side pocketing of debt funds. As the name suggests, the toxic assets in a debt fund are segregated and kept in a side-pocket. Hence the word side-pocketing came to be used. What the fund basically does is to hive off the toxic assets (like bonds of IL&LFS, DHFL and Jet Airways) into a separate side pocket fund and only the good assets will remain in the principal fund. But unit-holders in the fund are issued equivalent units of the side pocket fund too.

Side pocketing as a strategy is quite common in other countries as a genuine way of protecting the interests of genuine investors in the fund. For example, when a debt fund portfolio is hit by toxic holdings, the fund has the option to separate the specific bonds (side-pocket) into a side pocket portfolio. The side pocket portion of the fund will not permit inflows or even redemptions. This is important because normally when the NAV of the fund falls due to write off, the retail investors panic and sell out. At the same time, the smarter HNIs and distressed funds make a short term profit at the cost of genuine long term investors by buying these funds at low NAVs for a quick profit when the recoveries start.

First the write off will be taken. But that will affect the NAV of the side pocket portion of the fund and not the regular portion. Of course, the write off will still be taken but the side pocket ensures that short term traders do not make profits at the expense of genuine investors who exited the fund in panic. This is an incentive for the long term investors to stay on in the fund. Funds normally write off 75% in case of distressed assets and any recovery from these toxic assets are directly credited into the side pocket account and paid back to the investors.

In fact, there are a number of reasons side pocketing has not taken off in the case of Indian mutual funds. Fund managers normally worry that a side pocket could be seen as a tacit admission that parts of the portfolio are extremely stressed. This could impact the other funds of the MF also, something they want to avoid in the current circumstances. Secondly, the bigger challenge is regulatory since side pocketing is treated as change in fund strategy and will require case-by-case approval from the trustees of the fund. One way could be to permit this leeway to be included in the offer document but that will have to be approved by SEB. Finally, the tax aspects are not very clear. While some tax experts have argued that side pocketing will not be a transfer of shares, the CBDT is yet to issue a clarification on this subject. Smaller issues like the date of acquisition, purchase price will all be debatable issues.

However, you must realize that side pocketing is popular globally and it is a good way to address the concerns of the mutual fund investors.