Segregated Portfolio in Mutual Debt Funds

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ARUN SHINDE
Consultant, India

Segregated Portfolio in Mutual Debt Funds

Each mutual fund scheme has its own portfolio of investments. It focuses on that portfolio, on that scheme. But sometimes mutual fund investors get a communication message from the Asset Management Company (AMC) regarding "segregation of the portfolio in their scheme". This is because the mutual fund has created a "side-pocket" or "segregated portfolio" of unrated debt and money market securities. What does that mean? Read on...

Credit event
Suppose the debt funds invests in corporate bonds. Sometimes a bond defaults (=they do not pay) on payment of interest and principal. This is called a credit event. After a default the Net Asset Value (NAV) obviously receives intense criticism and immediately after the default the NAV of the bond is valued at zero.
For example, mutual fund F has a NAV of $20 and has a 10% exposure in bond B. On the day of obligation of the payment, bond B defaults. As a result, that bond is valued at zero while calculating NAV. The NAV of fund F is reduced to $18. Smart, observant investors, who know about this ambiguity, quickly get out of of the fund at a NAV of $20. The naive, gullible investors who are in there for the long term, stay with the fund losing out at the new, reduced NAV. It may be that these investors, who stayed with fund F, lose their patience after they find out they lost money and then get out in panic. They are not aware that the valuation of bond B which has become zero is not actually a zero and at some future date it might be recovered. The smart, short-term investors may even get in again at the reduced NAV before the recovery actually happens.
Fund F may want to avoid this kind of short trading as that practice is decreasing their reputation and harming the trust the long term investors have in the fund.

Creating a Segregated Portfolio
In order to protect the interests of all investors in case of a credit event, and also to deal with liquidity risk, mutual funds are permitted to create a "segregated portfolio" of debt and money market instruments. It is also termed as "side pocketing" or "side cart of portfolio".

Below chart explains how a segregated portfolio is created.



Total Portfolio: The scheme portfolio, including the security affected by the credit event.
Main Portfolio: The total portfolio, excluding the segregated portfolio.
Segregated Portfolio: This contains the security comprising of the debt market or money market instrument that is affected by a credit event (Bond B in our example). It is carved out from the total portfolio to form a segregated portfolio. In case of unrated debt or of money market instruments, a segregated portfolio may be created only in case of actual default of either the interest or the principal amount.

Creating a segregated portfolio is optional and can be created at issuer level or at security ISIN (International Securities Identification Number) level. The SID (Scheme Information Document) has the provisions for segregated portfolio with adequate disclosures. The AMC will require a detailed, written down policy on the creation of a segregated portfolio.

Following points are important in the process:

  1. The segregated portfolio shall be effective from the day of credit event.
  2. AMC shall issue a press release immediately with all relevant information pertaining to the segregated portfolio. The said information shall also be submitted to regulatory authorities.
  3. An e-mail or SMS should be sent to all investors of the concerned scheme.
  4. The NAVs of both segregated and main portfolio shall be disclosed separately from the day of the credit event.
  5. All existing investors in the scheme as on the day of the credit event shall be allotted equal number of units in the segregated portfolio as held in the main portfolio.
  6. No redemption and subscription shall be allowed in the segregated portfolio. However, in order to facilitate exit to investors in segregated portfolio, AMC shall enable listing of units of segregated portfolio on the recognized stock exchange within 10 working days of creation of segregated portfolio and also enable transfer of such units on receipt of transfer requests.

NAV applicability

  • Redemption: Investors redeeming their units will get redemption proceeds based on the NAV of main portfolio and will continue to hold the units of segregated portfolio.
  • Subscription: Investors subscribing to the scheme will be allotted units only in the main portfolio based on its NAV.

Investor communication

Communication needs to be sent to investors to help them to take informed decision with fate of their investment.
  1. A statement of holding indicating the units held by the investors in the segregated portfolio along with the NAV of both segregated portfolio and main portfolio as on the day of the credit event shall be communicated to the investors within 5 working days of creation of the segregated portfolio.
  2. NAVs of both portfolios be declared on daily basis.
  3. The investors of the segregated portfolio shall be duly informed of the recovery proceedings of the investments of the segregated portfolio. Status update may be provided to the investors at the time of recovery and also at the time of writing-off of the segregated securities.

Expenses

AMC shall not charge investment and advisory fees on the segregated portfolio. However, other expenses, subject to statutory limits can be charged, on a pro-rata basis only upon recovery of the investments in segregated portfolio. The costs related to segregated portfolio shall in no case be charged to the main portfolio.

The facility of creating a segregated portfolio is a tool to protect the interest of long term investors. It needs to be executed by AMC with due diligence. AMCs should not take undue credit risk in scheme portfolio. Any misuse of segregation of portfolio provisions may be considered seriously by regulatory authorities.

Disclaimer: Above information is compiled for informational and academic purpose only and should not be misconstrued as an investment advise. Under no circumstances does this information represent a recommendation to buy or sell mutual fund products..

  Meheresh
Management Consultant, India
 

Only Unrated Debt and Money Market Securities

Is this creation of a "side-pocket" or "segregated (...)

  Gandhi Heryanto
Management Consultant, Indonesia
 

Fund Return at the Due of Segregated Portfolio

The segregated portfolio is certainly beneficial f (...)

  ARUN SHINDE
Consultant, India
 

Securities for Which a Segregated Portfolio can be Created

@Meheresh: Thank you for your query. Creation of " (...)

  ARUN SHINDE
Consultant, India
 

Fund Return at the Due of Segregated Portfolio

@Gandhi Heryanto: Thank you for your question. Ye (...)

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