Summary:
This blog explains side pocketing in mutual funds, including what it means, why mutual fund houses use it, and how it works when a debt security faces a downgrade or default. It also breaks down the process of creating a segregated portfolio and its effect on investors.
The article examines the benefits, risks, and practical implications of side pocketing. Here you will understand how it can protect existing investors, limit panic-driven redemptions, and influence liquidity, NAV, and recovery outcomes.
Side pocketing in mutual funds
Side pocketing in mutual funds is a mechanism mainly used in debt funds when a bond or security in the portfolio faces a credit event, such as a default or downgrade. The distressed asset is separated into a separate portfolio called a ‘side pocket’.
Essentially, the side pocketing mechanism segregates a mutual fund portfolio into two sections: the main portfolio and a side pocket. Distressed assets, such as downgraded bonds or securities with default risk, are moved into the side pocket to prevent their falling valuation or low liquidity from affecting the main fund.
It is particularly useful for assets that cannot be sold instantly without significant losses but may recover value gradually. By isolating these securities, investors are protected from panic-driven redemptions and unnecessary realised losses during uncertain market conditions.
Thus, side pocketing reduces pressure on the Net Asset Value (NAV) of the fund and redemption capacity during market volatility.
How Side Pocketing Works in Debt Mutual Funds?
Here is the exact mechanism sequence of how a side pocket is created and managed:
The side pocket is created only after a serious credit event, such as a bond downgrade or a payment default. Say, a debt fund holds bonds of GHJ Ltd, and if the company misses an interest payment and its rating falls sharply, the fund may create a side pocket for those bonds.
The fund separates healthy securities from distressed assets into a side pocket. The NAV of the fund is also adjusted accordingly. For example, if a fund with ₹100 NAV holds a weak bond worth ₹5, the main portfolio NAV may fall to ₹95, while ₹5 shifts to the side pocket.
The existing investors receive units in both the main portfolio and the side pocket in the same proportion. Meaning, if an investor owned 1,000 units before side pocketing, they would continue holding 1,000 units in the main fund and 1,000 side pocket units linked to the distressed bond.
The main fund continues normal transactions, while side-pocket units stay locked until recovery. In this case, investors can still withdraw money from the healthy portion, but the side-pocketed units stay frozen until recovery happens.
Additionally, to provide liquidity, the side-pocket units are generally listed on stock exchanges, such as the NSE and BSE, within a specified period. This allows investors, who might not want to wait for recovery, to sell these units in the market at discounted prices.
Simultaneously, the fund house attempts to recover money from the defaulting issuer, and any recovered amount is distributed among the original side-pocket investors.
Once recovery is completed or the asset becomes worthless, the side pocket is closed.
Why Mutual Funds Use Side Pocketing During Market Stress?
In most cases, side pocketing is used when the fund cannot fairly value or easily liquidate a security. This separation helps in preventing panic-driven redemptions from hurting existing investors.
Here are some key reasons why side pocketing in mutual funds takes place:
- Credit rating downgrades: Debt securities facing significant rating cuts may carry higher default risk and create pressure on the fund portfolio.
- Payment defaults or delays: The issuers failing to pay interest or principal on time can reduce the value of debt securities.
- Liquidity problems: Some securities may stop trading actively, making them difficult to sell without major losses.
- Corporate governance issues: Fraud investigations or weak management practices can sharply impact investor confidence and bond prices.
- Regulatory or legal restrictions: Trading halts, court orders, or legal disputes may temporarily block asset sales.
- Major external events: Political instability, wars, or natural disasters can disrupt markets and freeze liquidity in certain securities.
Benefits and Drawbacks of Side Pocketing for Investors
Here is a comparative look at the benefits and drawbacks of side pocketing in mutual funds.
| Benefits | Drawbacks |
| Separates illiquid or distressed securities | Investors may face a lock-in until the side pocket is resolved |
| Reduces large-scale panic-driven investor withdrawals | Redemption flexibility becomes restricted during the period |
| Protects the main portfolio from further NAV damage | A portion of investor capital stays tied to uncertain securities |
| Provides time for recovery or orderly resolution | Losses may occur if the assets fails to recover value |
Real-World Example of Side Pocketing in India
The first side pocketing in mutual funds case in India took place in June 2019, when Tata Mutual Fund created segregated portfolios in three debt schemes after the downgrade and default concerns surrounding DHFL bonds.
Tata Mutual Fund had a total exposure of ₹198.22 crore to DHFL papers across six schemes as of 30 April 2019. Among the affected schemes, allocation stood at:
| Tata Corporate Bond Fund | 28.21% |
| Tata Medium Term Fund | 14.60% |
| Tata Treasury Advantage Fund | 3.77% |
Following the downgrade of DHFL’s long-term rating to ‘D’ (default) on 5 June 2019, the three schemes recorded one-day losses of:
| Tata Corporate Bond Fund | –29.69% |
| Tata Medium Term Fund | –12.31% |
| Tata Treasury Advantage Fund | –4.06% |
The fund house suspended fresh subscriptions in these schemes and offered investors a 30-day exit window without an exit load until 14 June 2019, before creating the segregated portfolio.
Investors who stayed invested received units in both the main portfolio and the side pocket, allowing them to benefit if recovery from DHFL happened later.
Another instance of side pocketing took place in February 2020, when UTI Mutual Fund and Nippon India Mutual Fund segregated their exposure to Vodafone Idea debt after CARE Ratings downgraded the company’s bonds to ‘BB-’, which was below investment grade.
UTI Mutual Fund created side pockets across five schemes with a total Vodafone Idea allocation of ₹186 crore. Meanwhile, the Nippon India Mutual Fund side-pocketed allocation worth over ₹227 crore across three schemes. Together, the segregated allocation stood at nearly ₹413 crore.
The move followed concerns over the ability of Vodafone Idea to pay massive AGR dues after the Supreme Court’s ruling.
How Investors Can Evaluate Debt Funds with Side Pocketing Risk?
Investors should examine the credit quality, portfolio concentration, and risk management approach of debt funds before investing.
- Check credit quality: Funds holding lower-rated bonds usually carry a higher probability of defaults and side pocketing.
- Review portfolio concentration: Excessive allocation to one issuer or sector can magnify losses during a credit event.
- Study past credit events: Previous downgrades, defaults, or segregated portfolios reveal the overall risk appetite of the funds.
- Assess liquidity and risk management: Funds with diversified holdings and stronger liquidity management are generally better prepared for market stress.
Common Mistakes Investors Make During Debt Fund Crises
In case of debt fund crises, investors often amplify their losses by chasing unusually high yields, panicking and prematurely selling off quality assets, or failing to diversify across credit ratings and issuers. Misunderstanding underlying risks leads to severe portfolio damage.
- Panic redemptions: Many investors exit immediately after negative news, sometimes locking in losses before any recovery takes place.
- Ignoring credit quality: Chasing higher returns without checking bond ratings or issuer quality can increase default-related risks.
- Overlooking portfolio concentration: Investing in funds heavily dependent on a few issuers can magnify the impact of a single downgrade.
- Assuming all debt funds are safe: Debt mutual funds carry varying levels of credit and liquidity risk, especially credit risk funds.
Should You Invest in Mutual Funds with Side-Pocketed Assets?
Side pocketing in mutual funds does not automatically make a debt fund bad. In many cases, it acts as a financial quarantine ward, isolating the infected bond before it spreads damage across the portfolio.
Investing in such funds depends on the reason behind the side pocketing, the quality of the remaining portfolio, and the fund house’s recovery approach. While some funds recover a meaningful portion of distressed assets over time, others may face permanent losses.
Investors should evaluate the fund’s credit quality, diversification, liquidity profile, and past handling of credit events before investing.
Conclusion
Side pocketing in mutual funds acts as a protective wall during debt market stress by separating distressed assets from the healthier portfolio. It helps control panic-driven redemptions, safeguards the fund’s NAV, and gives fund houses time to recover value from defaulted securities.
However, investors should carefully assess credit quality, liquidity, and portfolio concentration before investing in debt mutual funds carrying side pocketing risk.
FAQs
No, investors generally cannot redeem side-pocketed units directly from the fund house immediately. These units stay locked until recovery, resolution, or closure of the segregated portfolio. However, they may sometimes be traded on exchanges like the National Stock Exchange of India or BSE.
Side pocketing can be beneficial because it protects existing investors from panic-driven losses and prevents distressed assets from damaging the entire portfolio. However, it can also restrict liquidity and temporarily lock investor capital in uncertain securities.
Investors can reduce side pocketing risk by choosing debt funds with strong credit quality, diversified holdings, lower exposure to risky issuers, and disciplined risk management practices. Reviewing portfolio disclosures and credit ratings regularly also helps.
If the distressed issuer later repays the dues or the asset regains value, the recovered amount is distributed proportionately among the original side-pocket investors. Once the recovery process ends or the asset becomes worthless, the side pocket is closed.
