Mutual funds are built on the promise of transparency, liquidity, and professional management. Investors expect that their money will be deployed prudently and that risks will be disclosed. Yet, when financial shocks strike—such as corporate defaults or sudden credit downgrades—fund houses sometimes resort to a controversial tool: side pockets.
While side pockets can serve as a legitimate risk management practice, they also raise questions about whether they are used to genuinely protect investors or to quietly bury bad assets. This article explores how side pockets work, why they exist, historic cases, and what they mean for investors.
What Are Side Pockets?
A side pocket is a mechanism used by mutual funds to separate illiquid or distressed assets (such as defaulted bonds) from the rest of the portfolio.
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The main portfolio continues to hold liquid, performing assets.
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The side pocket contains toxic or impaired securities that are difficult to sell or value.
When a side pocket is created, the fund splits its Net Asset Value (NAV):
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Investors who remain in the scheme retain units in both the main fund and the side pocket.
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Investors who redeem after the side pocketing do not benefit from any future recovery of the distressed assets.
Why Do Funds Create Side Pockets?
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To Protect Existing Investors
Without side pockets, when defaults occur, panic redemptions ensue. Investors who rush out early leave the burden of toxic assets on those who stay behind. Side pockets freeze the bad asset fairly among all existing holders. -
To Manage Liquidity
Illiquid assets are hard to sell. By separating them, funds avoid “fire sales” that could further erode value. -
To Allow Potential Recovery
Sometimes, defaulted bonds may recover value after restructuring or legal settlements. A side pocket ensures that investors at the time of default share in any upside. -
To Avoid Continuous NAV Distortion
Marking down toxic assets daily creates volatility. A side pocket isolates that volatility, stabilizing NAVs of the main portfolio.
How Side Pockets Can Be Misused
While side pockets are meant to be protective, critics argue they also enable funds to mask poor decisions and delay accountability:
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Hiding Bad Bets: By moving distressed assets into side pockets, funds downplay the extent of their risk-taking.
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Cosmetic NAV Management: The main portfolio looks healthier, while the toxic reality is tucked away.
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Moral Hazard: Fund managers may take higher risks, knowing they can later shift losses into side pockets.
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Delayed Transparency: Side pockets reduce immediate visibility of how much value has been permanently impaired.
Real-World Examples
1. IL&FS Crisis (2018–2019)
When infrastructure giant IL&FS defaulted, several debt mutual funds were hit. To prevent panic redemptions, SEBI allowed funds to use side pockets. Distressed IL&FS bonds were isolated, and investors at the time of default became eligible for any recovery.
2. Franklin Templeton Debt Fund Wind-Up (2020)
Franklin Templeton shut six debt funds citing liquidity issues. While side pockets were used in some cases to isolate defaulted paper, critics argued that excessive exposure to high-risk issuers had already eroded trust. The episode highlighted how side pockets could not undo years of mismanagement.
3. DHFL Bonds
When Dewan Housing Finance Limited defaulted, multiple funds side-pocketed its securities. Recovery was uncertain, but the mechanism ensured that investors at the time of crisis shared in eventual payouts from resolution processes.
Regulatory View: SEBI on Side Pockets
In India, SEBI formally allowed side pockets in December 2018, after the IL&FS crisis. Rules require:
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Creation only when a debt security is downgraded to below investment grade.
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Board and trustee approval before side-pocketing.
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Disclosure to investors with clear segregation of NAV.
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Independent valuation of the distressed assets.
Globally, similar practices exist, though frameworks differ. In the US, hedge funds and private equity have long used side pockets to manage illiquid exposures.
Pros of Side Pockets
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Fairness: Prevents early exiters from escaping losses while leaving others stuck.
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Stability: Reduces panic-driven selling.
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Potential Recovery: Keeps alive the chance of eventual repayment.
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Transparency (in principle): Investors can see exactly which assets are impaired.
Cons of Side Pockets
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Trust Deficit: Retail investors often perceive side pockets as “hiding losses.”
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Complexity: NAV bifurcation and accounting can confuse small investors.
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Moral Hazard: Managers may use them to justify reckless investments.
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Illiquidity Lock-In: Investors cannot redeem the side-pocketed portion until recovery, which may take years.
Investor Impact
For investors, side pockets can be a double-edged sword:
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Short-Term Pain: NAVs drop immediately, reflecting the isolation of bad assets.
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Locked Capital: The portion in the side pocket cannot be redeemed, tying up money.
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Long-Term Hope: If recovery happens (via bankruptcy resolution, settlements, or legal action), side-pocketed units can deliver unexpected payouts.
Example: In DHFL’s case, investors eventually recovered part of the value years after default, which wouldn’t have been possible if the fund had liquidated the bonds in panic.
The Ethical Question
Are side pockets tools of prudence or of concealment? The answer lies in intent and execution:
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Prudence: If created transparently, with disclosure and regulatory oversight, they protect investors and uphold fairness.
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Concealment: If misused to bury repeated bad bets, they mask systemic risk-taking and betray investor trust.
The thin line between these two outcomes makes side pockets controversial.
How Investors Can Protect Themselves
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Study Fund Portfolios
Before investing, check the credit quality of securities. High exposure to lower-rated debt means greater risk of side-pocketing. -
Diversify Across Fund Categories
Avoid concentrating in aggressive credit-risk funds. Diversification reduces exposure to any single bad bet. -
Read Side Pocket Disclosures
Monitor fund communications carefully. If a side pocket is created, understand its valuation and recovery prospects. -
Prefer Transparent Fund Houses
Choose fund houses with strong governance and conservative risk policies. Their use of side pockets is more likely to be defensive than deceptive. -
Think Long Term
Side pockets are not always total losses—patient investors can sometimes recover value over time.
Future Outlook
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Regulatory Tightening: SEBI and global regulators are likely to introduce stricter reporting on credit risks to minimize misuse of side pockets.
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AI-Driven Risk Detection: Advanced surveillance could identify patterns of excessive exposure before defaults occur.
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Investor Awareness: As Indian retail participation in mutual funds grows, awareness campaigns may demystify side pockets.
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Market Discipline: The reputational risk of frequent side-pocketing may itself deter reckless fund managers.
Conclusion
Side pockets are not inherently fraudulent—they are a double-edged sword. At best, they preserve fairness during crises, ensuring that investors share both the pain of default and any recovery. At worst, they become a convenient drawer to stash away bad decisions, keeping the glossy picture intact while eroding long-term trust.
For investors, the key is vigilance. For regulators like SEBI, the mandate is to ensure that side pockets are used sparingly, transparently, and only when truly necessary. Because in the end, hiding bad assets—no matter how skillfully—cannot replace the core principle of mutual funds: protecting the small investor’s trust.
