Side pocketing is a relatively new and a not-so-familiar concept in mutual funds. This tactic rose to prominence when the default by IL&FS and some mutual fund plans were giving negative returns. This happened because certain mutual funds have disregarded entirely their exposure to IL&FS instruments even though the market regulator Securities and Exchange Board of India (SEBI) had permitted these funds a larger time frame.
How side pocketing works for investors
A side pocket is nothing but a type of account used in hedge funds to segregate illiquid assets from those assets of higher liquidity. This way, when any investment enters such an account, only the current members/contributors in that hedge fund can claim a share from it. Future investors will not get any share in the returns. As an accounting method, it can differentiate long-term (eg – equities) and non-liquid investments from the more liquid investments in a money market or debt scheme.
Whenever there is a dip in the ratings, the fund allocates the illiquid assets into a side pocket so that the current shareholders can avail its benefits. The Net Asset Value (NAV) of the fund will then reflect the actual value of the liquid assets. However, there will be a different NAV allocated to the side-pocketed assets too based on the appraised and attainable value for investors. This method makes sure that only investors who were in the fund during the write off can enjoy the perks of possible recovery.
A side pocket account works in the interest of those investors who wish to hold on to the units of the main mutual fund. This way, liquidity is not compromised for them when allotment and redemption occur now and then on more liquid assets.