What is side pocketing in mutual funds' management and how does it help investors?
Side pocketing means that you have a mainstream fund and if something goes wrong, you keep it aside in the side pocket, for it to be resolved. By doing so you ensure that the functioning of a mutual fund stays intact. Suppose there is a Rs. 1000 crore fund of which 50 crore is invested in a bond of a company which defaults, that is, it does not pay the interest and principle on time. So the day this happens, this fund immediately gets valued at 950 crore. Talking in per unit terms, assume that the fund has a NAV of Rs. 20, it will also lose 5 per cent and the NAV will now stand at Rs.19 but the problem is that this one rupee write off in the NAV is actually not worth a write-off. A part of this 1 rupee on per unit basis or the 50 crore write-off on an aggregate basis, maybe be recovered or a substantial part will be written off but that will be proven over a period of time.
A mutual fund has three kind of investors, the investors who are already invested, the investors who are getting out of the fund and the prospective investors who will invest into the fund. By side-pocketing this Rs. 50 crore on that day itself when it is hit by a write-off, will ensure that even if the investor withdraws his investments, he will be entitled for any recovery in the future on that fund. On the other hand, by not side-pocketing the crisis hit capital, there is a possibility that the investor moving out of the fund won't be entitled to any future recovery in the funds value. Now, when the written-off money will be recovered over a period, the prospective investors will get the benefits of it.
So side pocketing ensures that all the people who are genuinely entitled to get the benefits of the recovery in a fund will get it at a future date subject to realisation.