When you invest money in mutual funds, the biggest concern is that your money remains safe. Sometimes such a situation arises in the market when some companies suffer huge losses. At such a time, a rule comes in handy to reduce the losses of investors, which is called ‘side pocket’ or in simple words ‘separated part’. This method is like a protective shield for investors which prevents the entire money from being lost.
When a mutual fund invests money in the ‘bond’ i.e. debt paper of a company, then that company promises to return the interest and principal amount on time. When the company becomes bankrupt and stops repaying the loan, it is called ‘default’. In such a situation, the fund manager immediately separates that sinking investment from the remaining good and safe money. This system was implemented by the ‘Securities and Exchange Board of India’ (SEBI) in December 2018 after the ‘Infrastructure Leasing and Financial Services’ (IL&FS) crisis which acts as a safeguard for the entire mutual fund market in our country.
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This side pocket is like a separate pouch. When a company in a mutual fund’s portfolio defaults or its ‘credit rating’ falls too low, the bad portion is separated from the remaining good investments. Credit rating simply means how capable a company is in repaying its debt and this rating is given by agencies like ‘Credit Rating Information Services of India Limited’ (CRISIL) and ‘Credit Analysis and Research Limited’ (CARE). The fall in rating indicates that the company is in major financial trouble.
When and why did SEBI implement it?
Side Pocket was launched in India in 2018 after the ‘Infrastructure Leasing and Financial Services’ (IL&FS) crisis. It was a very big company which gave loans to build roads and bridges but it suddenly defaulted. After this, the bonds of ‘Non-Banking Financial Companies’ (NBFCs) i.e. those which are not banks but give loans and home loan companies also came into trouble. Many debt mutual funds held bonds of these companies, which created panic among investors and they started withdrawing their money en masse.
In view of this problem, ‘Association of Mutual Funds in India’ (AMFI), which is an organization of all mutual fund companies, proposed side pocket to ‘Securities and Exchange Board of India’ (SEBI) on 5 October 2018. After this, SEBI issued a circular on 28 December 2018 allowing debt mutual funds to separate the bad portion. In November 2019, SEBI also said that all new schemes must include the provision of side pockets.
How do side pockets work?
When the bonds of any company in a fund fall below investment grade i.e. its rating becomes very poor, then the ‘Asset Management Company’ (AMC) i.e. the one that runs your mutual fund scheme can create a side pocket. For this, approval of the trustees of the mutual fund is required. Once approved, the entire investment is divided into two parts.
The first part is the ‘Main Portfolio’ which contains all the good investments. Its ‘Net Asset Value’ (NAV) which is today’s market price of a unit of mutual fund is different and common investors can withdraw or invest their money from it whenever they want. The second part is the ‘side pocket portfolio’ which contains the bad investments which have defaulted. Its NAV is greatly reduced by separating it from the main fund.
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After the creation of the side pocket, the AMC informs all the investors through SMS and email and these units are also listed on the stock exchange so that if anyone wants to sell them in the future, they can sell them.
Real examples of side pockets in India
The first example of this in India was seen in 2019 during the ‘Dewan Housing Finance Corporation Limited’ (DHFL) crisis. This big home loan company suddenly defaulted due to financial crunch and gave up. The entire investment of about Rs 5,336 crore of mutual fund companies was stuck in this company. Then ‘Tata Mutual Fund’ became the first AMC which, under SEBI rules, separated the share of DHFL in its three schemes by putting it in a side pocket, so that the money of the remaining investors could remain safe.
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