Introduction
As an investor in India, you invest in mutual funds to create wealth, but if you hold a debt fund, there's a risk of defaults that can jeopardise your investment returns. With mutual funds, the concept of side pocketing effectively protects you from any such credit risk. SEBI published the side pocketing guidelines in 2018 to isolate illiquid or distressed debt assets from the rest of the assets of the fund, thereby protecting the NAV of the leading fund but also allowing the side pocket only to be exposed to investors who had exposure to the fund at the time of the credit event. Realising what side pocketing is in mutual funds will give you a better understanding of making your own decisions, whether to invest in a debt scheme.
What Is Side Pocketing?
Side pocketing separates distressed or illiquid assets in a mutual fund from the main account. An illiquid bond could be an example of a distressed asset. Side pocketing is initiated due to a distressed debt asset, such as following a default or substantial downgrade as defined under SEBI Guidelines. Where the bank would transfer the asset to the new account or sub-account, which minimises the troubles and protects the NAV of the primary account to ensure it doesn't drop suddenly due to the troublesome assets.
As for side pocketing, the mutual fund would allocate units for the asset value, like a separate account, depending on your current holdings. These units are valued independently, and once the underlying asset is sold, the investors can redeem the units, though liquidity may be limited. The leading portfolio continues as usual, protecting your ongoing investment from any direct impact related to the credit event.
How Side Pocketing Works
When a credit event occurs, it is quickly addressed through side pocketing in mutual funds. If the fund is notified of a credit event involving a specific asset, such as a bond downgrade, the board of trustees takes action to approve the side pocketing of the asset within one business day. The investment in question is set aside and will no longer be included in the NAV calculation for the leading portfolio.
Based on your original investment, you will receive units in the side pocket, but they will be treated as separate units with their own valuations. The units established from the side pocket can be traded on an exchange or redeemed by investors once the asset increases or is liquidated. The side pocketing is deliberate so that only investors present during the credit event must bear the impact of the credit event. It's an equal distribution of effects.
Why Side Pocketing is Important
Side pocketing mutual funds is particularly important for debt fund investors because it helps contain the impacts associated with credit risks. If side pocketing were not an option when a default occurred, the NAV of the leading portfolio could be significantly reduced, and investors would want to redeem their investment, leading to a fire sale of properly rated assets. This may escalate into a liquidity crisis, negatively affecting all investors. A side pocket allows for a focused problem to exist in its own section, and you know that the main scheme will operate normally while you monitor the performance of the side pocket separately.
Advantages of Side Pocketing
1. Loss Mitigation
A side pocket protects your leading portfolio from the volatility of troubled assets; the distressed securities are put in their own pocket so that your core investments cannot bankrupt you after one credit event.
2. Transparency
You know precisely how the credit events are impacting your portfolio because the NAV of the side pocket is calculated separately, so the distressed assets can be monitored without affecting the NAV of the main scheme.
3. Equitable Treatment
A side pocket allows for equitable treatment of all investors because it gives side pocket units only to investors who owned units in the main scheme when the credit event happened, preventing new investors from having to absorb the losses not incurred when they invested.
Issues Worth Understanding
Side pocketing in mutual funds is a great event; however, it involves a lot of complexities. The process, separating assets, allotting units, and valuing them, can be hard to grasp. Liquidity can be low because side pocket units may not trade frequently, thus hindering exiting. The value of distressed assets is also less specific, and possible markdowns can affect returns. Finally, using side pockets for investments lessens the leading portfolio's overall diversification, thereby slightly increasing risk.
Conclusion
Side pocketing is essential for our debt mutual fund investments, shielding you from credit concerns while maintaining equity and transparency. By knowing what side pocketing is for mutual funds, you will be better positioned to manage debt fund volatility. Remember to review your fund's side pocket policy and work with your financial advisor to ensure your investments align with your objectives as your portfolio seeks to withstand volatility in India's markets.
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