It's a technique to safeguard investors in instruments which have exposure to risky assets as for eg: in the case of recent IL&FS fall-out, managers in different schemes have been urging the regulator to allow them to go about side-pocketing. Here we will understand in detail what is side-pocketing in mutual funds and how it works.
How it covers or safeguards investors?
Using such a methodology, risky bets in the scheme are segregated from the safe and liquid investments which might get impacted due to credit profile of risky asset. And herein, the efforts are made to stabilize the net asset value of the scheme and also redemption in it as small investors do not get hit severely due to sudden exits by large investors.
The process involves separating illiquid or instruments in the default category from those that are liquid and hence safe. So, by and large there are two resultant schemes i.e. one comprising the illiquid paper and the other holding the good ones.
It is usually affected during a rate-downgrade and investors get exposure into the side-pocketed investments on a pro-rata basis. After the process is executed, investors will have to gauge for NAV for liquid investments as well as for those that have been side-pocketed.
How the methodology is useful?
To understand the use of this unique technique, we illustrate an example say a scheme with a corpus amount of Rs. 100 crore has exposure of Rs. 6 crore to assets of defaulting company and the rest in safe companies. Then even in such a case, companies with large exposure, tend to close their positions to avoid any loss further.
To meet the redemption, the fund managers need to offload exposure in good schemes while the rest in illiquid schemes remain intact. Thereby, the bad asset portion in the overall portfolio increases. With this exercise, net asset value of the fund sees significant drop.
So, to avoid such a situation, it is attempted to segregate debt papers of the company in crisis from the good ones. It is to be noted that investors in these funds will also get units in side-pocketed funds and as and when the defaulting company pays back its investors, investors in the scheme with exposure to such a holding will also get their money back.
The procedure thus prevents any kind of liquidity choking for investors in the main scheme.