Segregation of a portfolio, or "side-pocketing" refers to the segregation of a certain debt or money market instrument within a debt fund scheme, that have encountered credit-related challenges such as downgrades. This mechanism, introduced by the Securities and Exchange Board of India (SEBI) in December 2018, enables mutual funds to isolate these potentially risky assets within debt and money market instruments as a measure to protect the investors' interests.
This article looks into the concept of segregated portfolios and the mechanics of segregation, its triggers, and other factors associated with it.
What is Segregation of a Portfolio?
Segregation, in the context of mutual funds, refers to the process of isolating a specific asset or group of assets within a scheme and managing them separately from the main portfolio. This creates a segregated portfolio, essentially a sub-portfolio within the larger scheme. The assets in the segregated portfolio are held distinct from the remaining portfolio's holdings, with their own set of accounting records.
SEBI Definitions:
To ensure clarity, the Securities and Exchange Board of India (SEBI) has defined the following terms related to segregated portfolios:
Segregated Portfolio: A portfolio comprising debt or money market instruments affected by a credit event, that has been segregated within a mutual fund scheme.
Main Portfolio: The scheme portfolio excluding the segregated portfolio.
Total Portfolio: The scheme portfolio including the securities affected by the credit event.
By segregating assets, the fund house creates a separate compartment for potentially risky holdings, allowing for more focused management and protecting the main portfolio's value.
Why is Segregation Necessary?
Segregation serves several crucial purposes for both investors and fund houses:
Protecting Investor Capital: As mentioned earlier, segregation shields the main portfolio from the negative performance of a problematic asset. For instance, if a company the fund holds goes bankrupt, the segregated portfolio would hold that specific asset, preventing its decline from impacting the broader portfolio's value. This can be particularly beneficial for risk-averse investors seeking to minimise potential losses.
Facilitating Asset Resolution: Segregating an illiquid or distressed asset allows the fund house to manage its disposal more effectively. The fund manager can then focus on selling the asset in the segregated portfolio without hindering the liquidity of the main portfolio.
Mitigating NAV Volatility and Ensuring Fairness
SEBI Guidelines require the mutual funds to appropriately adjust the valuation of debt securities in the scheme in case of any downgrade in the credit rating to below investment grade or even lower. However, such markdown may reverse in the future, as and when recovery happens.
This creates a potential mismatch between investors as:
Investors who are in the scheme at the time of the markdown might bear the brunt of a lower NAV and will have to resort to redeem their units later, hoping that the asset recovers.
A different set of investors who join the scheme after the markdown might benefit from the rapid appreciation in NAV if the asset recovers, however, they have not beared the blunt of the lower NAV.
This creates mismatch as the investors invested before the markdown bear the blunt of the credit downgrade, and now need to wait till the asset recovers. However, the investors who join the scheme after the downgrade has occured, will only benefit from the asset recovery. Therefore, this would be unfair to the investors who were invested in the scheme before the downgrade occured. Thereby resulting in a situation where new investors enjoy better returns at the expense of earlier investors who faced the initial markdown.
For Example:
Consider a mutual fund scheme with a 10% portfolio in bonds of Company X, which defaults on interest payments. As per AMFI haircut guidelines, these bonds must be marked down, causing the NAV to fall immediately.
Now, let's assume full recovery happens in six months. This would push the NAV higher, benefiting only the investors holding units on that date, even if they weren't invested during the markdown.
Segregation of the portfolio as a Solution:
Segregation of the portfolio, or Side pocketing, addresses this fairness concern by segregating such exposures from the main scheme portfolio. The complete recovery from the segregated portfolio then belongs solely to the unit-holders of that specific portfolio.
Continuing with the example, if the portfolio had been side-pocketed earlier, any recovery in those bonds would only benefit the holders of units in the segregated portfolio, ensuring a fairer outcome for all investors.
Triggers for Segregation
Several factors can trigger the creation of a segregated portfolio, with SEBI guidelines outlining specific scenarios:
Credit Events at Issuer Level: Segregation is often triggered by credit events at the issuer level, meaning an event impacting the creditworthiness of the company that issued the debt security. These events typically involve downgrades in credit ratings by SEBI-registered Credit Rating Agencies (CRAs):
Downgrade to Below Investment Grade: If a debt or money market instrument held by the scheme is downgraded to "below investment grade" by a CRA, segregation becomes a potential course of action.
Subsequent Downgrades: Further downgrades of the same instrument from "below investment grade" can also trigger segregation.
Loan Rating Downgrades: Similar downgrades in loan ratings can also serve as a trigger.
Considering Multiple Ratings: In case of discrepancies in ratings assigned by different CRAs for the same instrument, the most conservative rating (indicating the highest risk) will be considered for segregation purposes.
Implementation at ISIN Level: Segregation is typically implemented at the ISIN level, a unique identifier assigned to each security. This ensures precise isolation of the affected asset within the portfolio.
Unrated Debt Instruments: For unrated debt or money market instruments issued by companies without any outstanding rated debt, segregation can occur only under specific circumstances:
Actual Default: If the issuer defaults on either interest or principal payments, segregation becomes a viable option.
AMFI Default Information: If AMFI (Association of Mutual Funds in India) disseminates information about an actual default by the issuer, segregation can be initiated.
Important Note: The creation of a segregated portfolio remains discretionary and subject to the decision of the fund house
Process of Creation of a Segregated Portfolio
The process of creating a segregated portfolio follows a specific set of guidelines outlined by SEBI:
AMC Decision and Trustee Approval:
Upon identifying a credit event, the Asset Management Company (AMC) decides whether to create a segregated portfolio.
Prior to initiating segregation, the AMC must seek approval from the scheme's Trustee.
Transparency and Communication:
The AMC immediately issues a press release disclosing its intention to segregate the affected debt or money market instrument and its potential impact on investors.
This press release prominently highlights that segregation is subject to Trustee approval and is prominently displayed on the AMC's website.
To prevent any disruptions during the approval process, the AMC suspends subscriptions and redemptions in the scheme until Trustee approval is received (typically within one business day).
Implementation upon Trustee Approval:
Once the Trustee grants approval, the segregated portfolio becomes effective from the date of the original credit event.
The AMC promptly issues another press release with all relevant information about the segregated portfolio, including submission of this information to SEBI.
All unitholders of the affected scheme(s) receive an email or SMS notification regarding the segregation.
The NAV (Net Asset Value) of both the segregated and main portfolios are disclosed from the date of the credit event.
Unit Allocation and Restrictions:
Existing investors in the scheme as on the date of the credit event are automatically allotted units in the segregated portfolio, mirroring their holdings in the main portfolio.
It's important to note that redemptions and subscriptions are not permitted directly within the segregated portfolio.
Exit Strategy for Segregated Portfolio Investors:
To facilitate exiting the segregated portfolio for investors, the AMC strives to list its units on a recognized stock exchange within 10 working days of creation. This allows for transfer of units upon receiving transfer requests.
When investors redeem units in the main portfolio after segregation, they receive redemption proceeds based solely on the main portfolio's NAV. Their holdings in the segregated portfolio remain unaffected.
New investors subscribing to the scheme after segregation will only be allotted units in the main portfolio based on its NAV.
Handling Non-Approval and Valuation:
If the Trustee disapproves the proposal for segregation, the AMC immediately informs investors through a press release. Subscription and redemption applications will then be processed based on the NAV of the total portfolio (including the potentially risky asset).
Independent Valuation:
Regardless of the segregation decision, the valuation of the entire portfolio (including the potentially risky asset) must consider the credit event.
SEBI regulations and circulars mandate that the portfolio be valued based on fair valuation principles, reflecting the realisable value of the assets.
By following these steps, the AMC ensures transparency, protects investor interests, and facilitates a more controlled approach to managing potentially distressed assets within the mutual fund scheme.
Conclusion
Ultimately, the decision to segregate a portfolio rests with the fund house. As an investor, it's crucial to stay informed about any segregation events within your chosen schemes and understand the potential impact on your investment.
Remember, for personalised investment planning tailored to your unique circumstances and risk profile, consulting a qualified financial counsellor is highly beneficial.
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