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

Image of a jeans pocket within a pocket representative of a mutual fund side pocket used to segregate bad bonds in the portfolio

Published: January 26, 2020 at 5:09 pm

Last Updated on

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?

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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.

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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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Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
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7 Comments

  1. Thanks again Pattu Sir. One more scenario: Say I had 100 units, and sold 50 units after the markdown event & before side-pocketing was done. Now say if the AMC provides side pocket units of 10 for every 100 units, will i get 10 units or 5 units? (I understood that changes of getting back after downgrade i slow, still wanted to know how its calculated in this case)

    1. Dear Friend,

      Those who exited after 16th but before 24th when the segregated portfolio wont get anything. Their loss is permanent. Read today’s livemint article on Franklin sidepocketing. “Investors in the affected schemes as on 24th January will receive units in the segregated portfolios. The move is a positive for existing investors since they will benefit from any eventual recovery in the bad debt in question. Conversely speculators will not now be able to take advantage of recovery. However those who exited the schemes between 16th and 24th January will not benefit. The fund house has come under criticism on social media for this delayed cutoff date for receipt of side pocketed units.”

  2. It is very much clear after reading this article. Thank you sir.
    One question: you have mentioned segregated fund cannot be redeemed. Does it mean, it can be redeemed only when or if full money recovered from the default company?

  3. What happens if side-pocket money is recovered with interest to compensate for time value?

    How to understand LTCG calculations in side-pocketing scenarios?

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