What is Side Pocketing in Mutual funds– Segregation of Portfolio

In recent times, the Mutual Fund industry has witnessed a series of downgrades and defaults. Starting from the IL&FS, Essel, DHFL, and now the latest one- Vodafone Idea, which made Franklin Templeton Mutual Fund segregate its holdings of Vodafone Idea debt.

(Know more about types and concept of mutual funds here)

It’s not only Franklin, even Birla, Nippon and other AMCs did the side pocketing in some of their funds in the recent past.

After reading about the same in Newspaper, one of my clients, having investments in Franklin Debt Funds, saw his portfolio and found one entry of segregated fund of Franklin in the same and wanted to know, what is this all about?

Other Investors who have seen or may see segregation in their debt funds, may also have similar queries, so this detailed post is on the same subject. You may find your answer here.

What is Side Pocketing in Mutual Funds or Segregation of the Portfolio?

Side Pocketing in mutual funds refers to the segregation of the units having the “below Investment-grade” securities from the mainstream portfolio, so that the existing investor in the scheme may get the benefit whenever the money recovers. This is also to discourage the new investors from entering the scheme after the event, so not take undue advantages of the situation.

Let us understand side pocketing or segregation, in Layman language with the help of an example.

Suppose, a mutual fund has invested in the bonds of 5 companies in equal proportion.

Now, Investors of the fund have exposure to 5 securities (bonds) as 20% in each company.

If any of the security defaults on interest obligation or principal repayment, then the Credit Rating downgrade will also happen along with fund house has to deduce the exposure of this security in the fund portfolio.

So, as per SEBI rules, the NAV of the fund has to be reduced by 20% immediately, writing off that security from the fund portfolio.

After this event, Mr. A feels that it is some temporary issue due to which the interest payment is delayed by the company and can be recovered later.

Seeing the reduced NAV, he intends to take advantage out of the expected recovery receipts from the bond, so he invests in the same. Now, if the Money gets recovered after some time, then Mr. A would be at an advantage, as the NAV would jump immediately on rating upgrade or money recovered, which was reduced earlier due to the default.

However, the existing investor who stayed in the portfolio would see only the recovery and not the profits. Also, the investor who for some reasons exited the fund after the downgrade/default event was at an absolute loss.

To address this issue, the provision of side pocketing is introduced by SEBI.

Now in this case, if side pocketing is implemented, the security of the company which has defaulted, would be separated out from the mainstream portfolio and no new purchases/redemptions are allowed from the same.

(Read: Types of Debt Mutual funds)

When is Side Pocketing in mutual funds done?

As per SEBI regulations, side pocketing in mutual funds can be done only when there is an actual default of either the interest or principal amount or if a debt instrument is downgraded to below investment grade or BBB rating by credit rating agencies, then the fund house has the option to create a side pocket.

It is not compulsory, it is at the discretion of the Fund House, whether to segregate or not.

What happens after that?

When side pocketing in mutual funds is done, the fund house is not sure whether the security would be realizing something later or not, but the NAV of the fund is reduced with immediate effect, to the extent of the exposure to such securities.

So, in this scenario, the existing investors of the fund are allotted an equal number of units in the segregated portfolio as held in the main portfolio and no redemption or purchase is allowed in the segregated portfolio.

These units are then listed on the stock exchange within 10 days and investors can sell them within the 30 days window, without any exit load.

If the Corporate borrower pays the dues in the future, the NAV of the Segregate portfolio gets declared and money gets immediately refunded to the unitholders.

The new investors entering the scheme after, and the investors who had exited the fund before this exercise, would not be entitled to the receipts from the same, in the event of recovery from this segregated security.

The reason being, either these investors did not invest in this security or deliberately exited from the same, before segregation, then ideally, they should not be entitled to receive the repayments from it?

Only the existing investors, holding the security would be entitled to the receipts from recovery.

(Also Read: Why Debt investments should be part of your portfolio?)

Conclusion

It’s a well-known fact that even debt mutual funds have some inherent risks in it. Credit Risk is one of them. Side pocketing in mutual funds or Segregation of the Portfolio is a quite beneficial approach for the investors who loses their hard-earned money due to such defaults in the debt funds. And it is quite logical that those who actually lose should only get the benefit of recovery too, and no other person should be allowed to make use of the situation as used to happen earlier.

(Also Read: Taxation of Segregated Portfolio Receipts)

This post is written by Varun Baid