- When an asset is illiquid, it does not mean that the asset has no value. Illiquid assets are difficult to sell because there may not be many buyers interested in purchasing the asset. For example, a painting by Vincent Van Gogh holds plenty of value, but few buyers are interested in and able to purchase a Van Gogh painting, making it an illiquid asset. More common examples of illiquid assets include real estate, antiques and securities that currently have low trading volume, such as those from companies delisted from the major stock exchanges. Investors often refer to stocks with low trading volume as thinly traded stocks.
- A hedge fund manager may decide to create a side pocket account if the market conditions for selling a particular asset become unfavorable. When this occurs, the asset becomes illiquid, and the fund may incur losses if the manager sells the assets at that time. To avoid such losses, she will hold the illiquid assets in a side pocket account until the market turns around. For example, a hedge fund manager may decide to put any real estate assets into a side pocket account when the housing market is experiencing a downturn.
- When a hedge fund manager creates a side pocket account, only those currently invested in the hedge fund are entitled to any gains realized when the manager decides to sell the assets held there. For the majority of side pocket hedge funds, investors cannot generally redeem their shares until the fund manager sells the side pocket assets or moves them out of the side pocket account and into the general portfolio account. Investors who buy shares of the fund after the manager creates the side pocket account do not receive any gains realized when the assets are sold.
- Since 2010, the Securities and Exchange Commission (SEC) has launched numerous investigations into side pocket accounts. These investigations have been launched in response to investor complaints regarding their inability to redeem their side pocket hedge fund shares on demand. The SEC investigations include the valuation methods that fund managers use for side pocket accounts, due to a concern that the managers may be overstating their value. The SEC is looking into the general lack of disclosure given to investors regarding asset allocation percentages from the general portfolio into side pockets.