What Is Side Pocketing in Mutual Funds?

In mutual fund investing, there’s always a chance of sudden risks from troubled assets. That’s where side pocketing comes into play. Side pocketing is a strategy used by fund managers to separate high-risk or defaulted assets from the rest of the portfolio. This move helps protect investors by isolating potential losses and maintaining stability in the fund’s Net Asset Value (NAV). 

This blog will discuss how side pocketing works, its impact on your investment, and what you need to know before choosing a fund that practices it.

How Does Side Pocketing Work in Mutual Funds?

Side pocketing in mutual funds is a method fund managers use to separate troubled assets from the main portfolio. Here’s how it works, step-by-step:

Step 1 . Identify Troubled Assets

The fund manager first identifies assets that have encountered problems, like bonds from companies unable to pay debts or assets that suddenly lose value and become hard to sell.

Step 2. Create a Side Pocket
Instead of keeping these high-risk assets in the main portfolio, the fund manager sets up a side pocket. This is a separate section within the fund specifically for troubled assets.

Step 3. Transfer Assets to the Side Pocket

The identified assets are moved into the side pocket. This separation helps protect the main portfolio from the impact of these risky assets, keeping it more stable.

Step 4. Access Limited for New Investors

Only investors who had already invested before the side-pocketing could access the side-pocketed assets. New investors will only have shares in the main portfolio, shielding them from the risks.

Step 5. Monitor and Wait for Recovery

The side-pocketed assets can’t be easily sold. If they recover value or are eventually sold, any gains or losses go to the original investors. This approach helps stabilise the main portfolio while waiting for the outcome of the troubled assets.

What Is the Impact of Side Pocketing on NAV?

Side pocketing has a direct impact on a mutual fund’s Net Asset Value (NAV), as it separates risky or low-value assets from the main portfolio. When side pocketing occurs, the troubled assets are moved into a separate section within the fund. This process helps stabilise the NAV of the main portfolio because the problematic assets are no longer included in its daily value calculation.

For investors, this means that the main portfolio’s NAV reflects only the healthier, more stable assets, making it less affected by sudden drops in value from risky assets. The side-pocketed assets do not impact the NAV of the main portfolio, keeping it steady for regular investors.

However, the NAV of the side pocket itself may fluctuate based on any change in the value of the risky assets it holds. If these assets regain value, investors benefit. If not, the side pocket may eventually lose value, impacting only those originally invested before the side pocketing happened.

Importance of Side Pocketing

Side pocketing is an important tool in managing risk within mutual funds. Here’s why it matters:

1. Shields the Main Portfolio’s Value

• Risky assets are separated from the main portfolio.
• Keeps the main portfolio’s NAV stable and less affected by volatility.
• Protects regular investors from sudden losses due to troubled assets.

2. Protects Existing Investors

• Only existing investors at the time of side-pocketing have access to the side-pocketed assets.
• New investors are shielded from risks tied to these troubled assets.
• Ensures that gains or losses in the side pocket only impact those who originally invested.

3. Allows Time for Asset Recovery

• Gives fund managers time to hold or work with troubled assets.
• Prevents the need to sell risky assets at a loss during a market downturn.
• Allows original investors to benefit if the asset eventually regains value.

Advantages and Disadvantages of Side Pocketing in Mutual Funds

Side pocketing can help manage high-risk assets within mutual funds, but it has both benefits and drawbacks. 

Conclusion 

Side pocketing is a valuable tool in mutual fund management, especially when managing troubled assets. Isolating risky assets helps maintain NAV stability and offers protection to investors from sudden losses. However, it comes with its own set of challenges, like reduced liquidity and limited access to the side-pocketed assets. It’s essential to weigh these pros and cons and align them with your risk tolerance. For those looking at funds with side pocketing, understanding the impact on returns and fund access can make a difference in how well your investment aligns with your financial goals.