The Securities and Exchange Board of India (SEBI) introduced the side pocketing framework in December, 2018 on the back of IL&FS fallout, which had failed in meeting its commitments to creditors and lenders, putting a lot of pressure on the net asset value of most debt funds that owned IL&FS group papers in their portfolio.
The side pocketing is a framework that allows mutual funds (MFs) to segregate the bad assets in a separate portfolio within their debt schemes.
Under the side pocketing, to protect retail investors from the risky investments, the SEBI has allowed MFs to separate the stressed assets from good quality liquid assets.
If a debt instrument is downgraded to default rating by credit rating agencies, then the MFs have the option to create a side pocket so that good assets can be ring-fenced.
All existing investors in the scheme are allotted equal number of units in the segregated portfolio as held in the main portfolio and no redemption or subscription is allowed in the segregated portfolio.
Thereafter, the units (in the segregated portfolio) have to be listed on a stock exchange within 10 days to facilitate exit of the unit holders.
Effectively, this makes the price discovery of the bad assets with investors having the freedom of either selling it at prevailing price or holding it if they expect the value to recover in future.
Misuse of Side pocketing
It could be misused by MFs to hide their bad investment decisions.
The SEBI, however, has put in place checks and balances to minimise any such misuse.
The Trustees of all fund houses will have to put in place a framework that would negatively impact the performance incentives of fund managers, chief investment officers (CIOs), etc. involved in the investment process of securities under the segregated portfolio.
The SEBI has also stated that side pocket should not be looked upon as a sign of encouraging undue credit risks as any misuse of the option would be considered serious and stringent action can be taken.