What is a ‘side-pocket’ in mutual funds? How does it work?

A simple explanation of what is a 'side-pocket' in mutual funds, when it is created, how is it useful to investors. An easy-to-understand FAQ

Published: January 26, 2020 at 5:09 pm

In the aftermath of Franklin AMC creating side-pockets in its debt funds holding Vodafone Idea bonds, let us discuss what is a mutual fund side-pocket? When and how is it used? What does it mean? Will it help investors and what investors in such funds should? What about those who put in money after the write-down?

Before we begin, you can now watch for free the first lecture of the goal-based portfolio management lecture series. The contents of the course and FAQ can also be found there. In case you missed it, check out SEBI RIA Avinash Luthria’s hard-hitting article: Why SEBI could kill off Fixed-Fee-Only Fin Planning & Jack Bogle’s legacy

What is a mutual fund side-pocket? When a bond held in a mutual fund becomes junk, that is unable or unlikely to pay interest, it is separated from the portfolio. This segregated portfolio is known as a side-pocket.

When is a side-pocket created?  When there is an actual default of either the interest or principal amount or if rating agencies have labelled the bond as below investment grade or BBB rating. A provision for creating a side-pocket must be present in the scheme document. See for example CRISL’s circular on Vod Idea dated Jan 24th 2020.

It is important to appreciate that the initial SEBI circular (Dec 28th 2018) on side-pocketing allowed funds to create one in the event of a credit downgrade. Later, in Nov 2019, SEBI modified the rules and allowed side-pocketing only in the event of an actual default or bond being labelled “junk” (below investment grade).

SEBI has also made it mandatory for AMCs to intimate AMFI upon default or delay in payment from a bond issuer so that other AMCs can take appropriate action.

Why is a side-pocket created? To ensure portfolio exposure to bad bonds does not increase due to redemptions, to ensure new investors do not profit from the fall in case of a recovery.

Consider an open-ended mutual fund with a bad bond where fresh purchases and redemptions occur each business day. As people pull out of the money the exposure to the bad bond will increase quickly and dangerously.  Fresh investments will have to be allotted to a bond that has no or uncertain value. Investments made after the fall may get an unfair advantage if the bond is able to honour its debt.

Does the creation of a side-pocket or segregated portfolio mean investors can recover losses from the bond default? No. It only means fresh purchases will not involve the bad bonds.

Is a side-pocket better than a markdown? No. If the bad bonds are fully and completely marked down to zero, then it is effectively removed from the portfolio. In a side-pocket, it is kept aside, “just in case”. In both cases, the loss is permanent, even if there is a full recovery due to the time value of money.

In other words, a full markdown is throwing trash in the street garbage bin where the truck will pick it. Side-pocketing is preserving garbage at home. In both cases, it is garbage and in both cases, there is a “cost” (or loss).

It may be of interest to note that Franklin’s recent Voda markdown was not a complete markdown.

Can a side-pocket be created with stocks? No. SEBI rules only permit side-pockets to contain “debt or money market instruments”

Can an equity fund have a side-pocket?  Yes, if they contain bonds below investment grade.

Is it mandatory for a fund to have a side-pocket? No. It is up to the AMC.

Is side-pocket the same as a segregated portfolio? Yes.

What happens when a side-pocket is created? The portfolio of the fund will be divided into two: the main portfolio containing the good bonds and a much smaller (hopefully!) segregated portfolio containing the bad bonds. Each portfolio will have its own NAV. Units will be allotted to investors on a pro-rata basis (in proportion) to the amount invested and portfolio weights. Investments and redemptions can only be made in the main portfolio.

Can we redeem units from the segregated portfolio? Practically no. Technically, they will be listed in the secondary market. Unitholder may sell these to prospective buyers.

Can we invest in the segregated portfolio? No. When on a normal day, debt funds are difficult to understand, it is baffling to note many people interested in buying debt funds holding bad bonds post-default.

If I exit before the creation of the side-pocket, will I get the benefit of the side-pocket? No. Only investors who held units of the fund as on the credit event (eg Jan 24th, 2020 for Franklin) are eligible. That is the date on which the bond was degraded below investment grade.

If I buy after the creation of the side-pocket, will I benefit if the bond issuer pays back? No. Your investments will be in the main portfolio and not the segregated portfolio that has bad bonds.

If I buy after the fall in the NAV but before the creation of the side-pocket, will I be eligible for a side-pocket? Yes. Since you held units on the date of creation of the side-pocket (which is usually within a day after the credit event) you will be eligible for side-pocket. However, since you probably invested with the hope of making a quick gain, that chance is

What should investors affected by Vodafone Idea downgrade do? Those who are surprised by this and invested only on the basis of past performance should exit from the main portfolio and move on. Others who can bear the risk and do not have an immediate need for the money can stay put.

Once a side-pocket has been created what are the chances of recovery? Quite remote. Businesses at that level of debt can only sink further down.

What happens to the side-pocket if the AMC is able to recover all dues? The side-pocket will be dissolved and returned to investors in exchange for the units they hold.

Will the side-pocket have expenses associated with it? Until the dues are recovered no. After recovery, total expense ratio (excluding the investment and advisory fees) can be charged on a proportional basis.

If you have any other questions on side-pocketing, please comment below. Also see: Was Franklin AMC right in marking down Vodafone Idea Bonds?

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