Side Pocketing in Mutual Funds, Explained Simply

When a bond defaults or its rating is cut sharply, its value drops. Without side pocketing, investors who rush to redeem first could exit before the full loss shows up, leaving the loss with those who stay. New investors could also enter cheaply and benefit unfairly from a later recovery.

Side pocketing stops this. It separates the problem so that everyone who was invested at the time is treated equally.

1. A credit event: a bond held by the fund is downgraded below a certain level or defaults.

2. Separation: the fund house moves that bond into a separate segregated portfolio, if the scheme allows it and its trustees approve.

3. Units for everyone: every investor on that date receives units in the segregated portfolio, equal in number to their units in the main fund.

4. Main fund continues: the main portfolio, now without the troubled bond, carries on with normal buying and selling.

On the day of separation, the main portfolio NAV falls by the value of the troubled bond, since that bond is no longer part of it. The segregated portfolio has its own NAV, which reflects what the troubled bond is currently valued at.

Your total value is the main units plus the side pocket units. Our page on NAV explains how fund values are calculated.

You cannot redeem segregated portfolio units with the fund house in the normal way. They are usually listed on a stock exchange so they can technically be traded, but in practice there is often very little buying interest.

Most investors simply hold them and wait for any recovery. You can still redeem the main portfolio units as usual.

If the borrower later repays all or part of the money, the fund house pays it out to the holders of the segregated units, in proportion to their holding. The segregated portfolio is then closed.

Recovery can take months or years, and sometimes only part of the money comes back, or none at all. There is no way to know in advance.

New investors who buy units after the separation get only main portfolio units. They do not share in the troubled bond, either its losses or any recovery.

This is exactly the fairness side pocketing is designed to achieve.

Side pocketing is used in debt and hybrid funds that hold corporate bonds. Funds that hold mostly government securities rarely face this, because default risk on government bonds is very low.

Funds that take more credit risk, such as credit risk funds, are more likely to face such events. Our pages on credit risk funds and corporate bond funds explain the differences.

Side pocketing does not mean the fund house did something illegal. It is a SEBI-approved tool for handling a real credit problem fairly. That said, it does show that the fund took a credit risk that went wrong.

Our page on who regulates mutual funds explains the safeguards around fund houses and trustees.

Your statement will show both the main and segregated units. For tax, the cost of your original investment is split between the two in a defined way. The details depend on the rules at the time, so a tax adviser can confirm your position.

Our page on the capital gains statement explains where to find these figures.

• Check the credit quality of a debt fund holdings in its fact sheet.
• Read the riskometer and the potential risk class shown for the fund.
• For emergency money and short goals, prefer funds that hold high-quality or government securities.
• Do not choose a debt fund only because it showed a higher recent return.

Our pages on the riskometer and debt funds explain how to read these risks.

Not automatically. After separation, the main portfolio no longer holds the troubled bond. Look at what it holds now, whether it still suits your goal, and whether the fund house manages credit risk sensibly.

If you do decide to switch, check the exit load and tax first. Our page on when to sell a mutual fund gives a calm way to decide.

Say you hold 1,000 units of a debt fund. One bond in the fund, making up a small share of it, defaults. The fund side pockets that bond. You now hold 1,000 units of the main portfolio and 1,000 units of the segregated portfolio.

The main NAV drops by roughly the bond share. The side pocket NAV shows the bond current, much reduced value. If the borrower later pays back part of the money, you receive your share of that payment, and the side pocket closes. These figures are only for illustration.

When a fund side pockets, the fund house must inform investors and publish details of the segregated portfolio, including its NAV and holdings. You should receive an email or SMS, and it will appear in your next statement.

If you are unsure what a message means, check it against the fund house website or your registrar portal, and never act on links from unknown senders.

• Side pocketing separates a troubled bond from a debt fund.
• You get units in both the main and segregated portfolios.
• Recovery, if any, goes to those invested on the separation date.
• Check credit quality to reduce the chance of facing it.

We are distributors rather than investment advisers and we recommend no schemes. If you hold a fund that has side pocketed and want help understanding it, get in touch.