Side Pocketing in Mutual Funds
Side pocketing is a mechanism introduced by SEBI in December 2018 that allows mutual fund schemes to segregate distressed or defaulted debt securities into a separate portfolio, protecting continuing investors from being disadvantaged while ensuring that proceeds from recovery of the segregated assets are distributed proportionately to all investors who held units at the time of the credit event.
The concept of side pocketing emerged in India as a direct response to the IL&FS crisis in September 2018, when several debt mutual fund schemes held paper issued by IL&FS entities that defaulted suddenly, causing sharp and unexpected NAV falls. Investors who redeemed after the default were protected (they had already exited at pre-event NAVs), while those who held on bore the full brunt — a structurally unfair outcome that SEBI moved to address.
SEBI's circular dated 28 December 2018 on 'Creation of Segregated Portfolio in Mutual Fund Schemes' allowed AMCs to create a segregated portfolio when a debt security in their scheme's portfolio received a credit rating downgrade to 'below investment grade' or below, or when a credit event (default on principal or interest) occurred. Once activated, the scheme is bifurcated: the 'main portfolio' contains all good assets and continues normal NAV calculation and transactions; the 'segregated portfolio' (side pocket) holds only the distressed security, with its own unit count and NAV.
Existing unitholders at the time of segregation receive an equal number of units in the segregated portfolio as they hold in the main portfolio. Importantly, from the date of segregation, no fresh purchases can be made in the segregated portfolio — only redemptions if liquidity is available. This structure ensures that new investors cannot buy into a near-worthless asset at a distressed NAV and benefit disproportionately if recovery occurs.
Past cases where side pocketing was activated include Franklin Templeton's debt schemes (though those were eventually wound up under a different process), and some schemes holding Vodafone Idea paper, ADAG group paper, and Yes Bank AT1 bonds during 2019-2021. Each case demonstrated both the utility and the limitations of side pocketing — while it protected fair treatment among investors, the recovery process in side pockets can take years, and in some cases the eventual recovery was minimal.
AMCs are required to disclose the activation of side pocketing on their websites and report it to SEBI and AMFI immediately. The side pocket NAV is tracked separately, and any recovery (from the distressed issuer paying partial principal or interest, or from a resolution under the IBC) is passed on to unitholders of the segregated portfolio on a pro-rata basis.