Is Side Pocketing A Safety Net or a Two-sided coin?

Mutual funds are designed to pool money from investors and allocate it across different assets to generate returns. But what happens when some of these assets turn risky or illiquid? That’s where side pocketing comes in—a concept that sounds technical but is, at its core, a risk management strategy to protect investors from sudden losses.

Imagine you are driving on a highway when suddenly one of your car's tyres bursts. Instead of abandoning the whole car, you pull over and replace the damaged tyre with a spare. This way, you can continue driving safely while dealing with the faulty tyre separately. In mutual funds, side pocketing works the same way, it isolates troubled assets after a financial mishap, allowing the rest of the fund to function smoothly.

Side pocketing in mutual funds

Side pocketing is the process of isolating illiquid, distressed, or hard-to-value assets from the main portfolio of a mutual fund. When a fund manager identifies a risky asset—typically after a credit downgrade, default, or liquidity crisis—it is moved into a ‘side pocket,’ leaving the main portfolio unaffected.This ensures that new investors don’t unknowingly buy into a fund with toxic assets, and existing investors get a clearer picture of their holdings.

History of side pocketing

Side pocketing in mutual funds emerged as a protective measure in response to liquidity crises and credit events. During the 2008 global financial crisis, Indian money markets faced severe liquidity issues. Mutual funds struggled with large-scale redemptions, forcing them to sell high-quality liquid assets, which left remaining investors exposed to illiquid instruments. Although SEBI and the RBI introduced temporary liquidity measures, side pocketing was not formalized at the time.

The concept gained official traction in December 2018, following the IL&FS crisis, which shook the Indian debt market. Several debt mutual funds had invested in Infrastructure Leasing & Financial Services (IL&FS), which suddenly defaulted. This caused the fund’s Net Asset Value (NAV) to plummet, impacting all investors—even those who joined after the crisis.

Shortly after, defaults by DHFL triggered further redemptions, adding to the volatility. The crisis highlighted the need for a mechanism to separate distressed assets from liquid ones, preventing the entire portfolio from being affected. In 2019, SEBI, after consulting with the Association of Mutual Funds in India (AMFI), formally approved side pocketing. This allowed mutual funds to create separate portfolios for illiquid or downgraded securities. Investors holding units at the time of the credit event were allotted their share in the side pocket, ensuring they benefited from any future recovery. By isolating troubled assets, side pocketing protected existing investors from value erosion due to forced selling and prevented new investors from unfairly benefiting from potential recoveries.

Real examples of side pocketing in India

Several Indian companies have faced financial distress, leading to their downfall and, in some cases, triggering side-pocketing by mutual funds.

Here are a few examples of companies where financial mismanagement and mounting debt mutual funds returns led to their downfall, triggering protective measures like side pocketing in mutual funds.