November 26, 2019

All about Segregation or Side Pocketing in Mutual Funds

Since a few days, one by one Mutual Fund Companies may be sending you an email with the intimation that they are implementing the Segregation or Side Pocketing in Mutual Funds to their debt mutual funds.

Let us understand the concept of Segregation or Side Pocketing in Mutual Funds in detail.

What will actually happen if there is a downgrade or default in your Debt Mutual Funds?

Before going further to understand the concept of Segregation or Side pocketing in Mutual Funds, let us first understand how the credit downgrade or default will affect your Debt Mutual Funds.

Let us assume that the NAV of a Debt Mutual Fund is Rs.10 and the number of units is 100. Therefore, the AUM will be Rs.10*100=Rs.1,000.

Assume there are 50 retail investors and each of them is holding one unit of this fund. Hence, total AUM holdings by these retail 50 investors can be calculated as Rs.10*50 (total units held by these retail investors)=Rs.500.

Assume there are 5 big investors and each of them is holding 10 units of this fund. Hence, the total AUM holdings by these big investors can be calculated as Rs.10*50 (total units held by these big investors)=Rs.500.

Assume that the Mutual Fund company invested around Rs.200 in ABC Company NCD (which is 20% of total AUM). If there is a default by this ABC Company NCD. Then usually these two scenarios may happen.

# When we withdraw the money in a PANIC

If the AMC decided to waive off 50% of its exposure i.e Rs.100. The AUM will be Rs.9,00 and NAV will be Rs.900/100=Rs.9.

Now due to fear, these 5 big investors try to withdraw their money from this fund. So they wish to withdraw 50% of their holdings. So in total, they requested 25 (50% of their total holding) units withdrawal and the total amount that can be withdrawn from them will be 25*9=Rs.225.

However, the mutual fund company can’t sell the ABC Company NCDs as it already defaulted. Hence, to meet the redemption request of these 5 big investors, the mutual fund company will sell some holdings from the good debt part of the debt fund and pay to these 5 big investors.

Notice that when there were all investors invested in a fund and ABC Company NCDs defaulted, the exposure to the fund was 20%.

Now the actual AUM of the Fund is Rs.675 (Rs.9 NAV*75 Units). With this, the remaining unitholders loss is currently

After a few days, Mutual Fund Company decided to waive another 50% of ABC Company NCDs holding i.e Rs.100. Now the AUM is reduced to Rs.575 and units with the funds are 75. Therefore the NAV will be Rs.7.66 (Rs.575/75).

If the big 5 investors hold the units of 25, then the AUM will be Rs.800 and as the number of units used to be 100, the NAV will be Rs.8 (Rs.800/100).

Noticeable few things from the above example are as below:-

  • Initial withdrawal immediately after the 50% waived off benefited to those 5 big investors as at that time the NAV was Rs.9.
  • After the 100% waived off of ABC Company NCDs by Mutual Fund, it reduced the NAV of the Fund to Rs.7.66.
  • If the 5 big investors stayed in the fund without bothering the default, the NAV be Rs.8.

Usually, when default or credit downgrade happens, few BIG or SMALL investors panic and ultimately run behind withdrawal leading to sudden fall in NAV and heavily impacting on those who stayed in the fund. Two things happen here when such a huge redemption takes place.

# As explained above, NAV will drop drastically.

# If Mutual Fund company not waived off the defaulted or downgraded company, the exposure to it under the AUM goes on increasing. For example, when the AUM was Rs.1,000 the exposure to bad company Rs.200 means 20%. However, assume there is a sudden withdrawal request of Rs.500, then due to illiquidity and unable to sell the defaulted or downgraded company exposure, the mutual fund company by default will sell the quality holdings of the company. Hence, in remaining Rs.500 AUM, the defaulted or downgraded company exposure still remains Rs.200 leading to increased exposure of 40%.

Hence, the existing unitholders’ risk increased from earlier exposure of 20% to the current exposure of 40%.

# When we invest in a fund due to drastic fall in NAV

Considering the same scenario that the mutual fund company waived off the 50% of exposure to ABC Company’s NCDs value, the NAV will be Rs.9.

Instead of PANIC withdrawing, the big investors felt that the ABC Company may pay it’s dues to Mutual Fund Company in the future and the fall in NAV is an opportunity to invest more.

They thought to buy 10 units in total (2 units by each of these 5 investors) in this fund again. Due to this, the units increased from earlier 100 to 110. The AUM is Rs.900 (earlier AUM)+Rs.90 (10 units*Rs.9)=Rs.990 and NAV is the same as that of Rs.9 only (Rs.990 new AUM/110 new units).

Assume that after few days the ABC Company paid the NCDs dues of Rs.200 to the Mutual Fund Company. Due to this, the AUM is increased to Rs.1,190 (Rs.990+Rs.200). Now the number of units in mutual funds is 110 and AUM is Rs.1,190. Therefore the new NAV will be Rs.1,190/110=Rs.10.80.

This again benefitted the investor who took the daring step to invest when there is a default by ABC Company Ltd.

Noticeable few things from the above example are as below:-

  • Initial investment opportunity immediately after the 50% waived off benefited to those 5 big investors as at that time the NAV was Rs.9 (10% lower).
  • After the mutual fund company received the full amount, the NAV jumped from Rs.9 to Rs.10.80, which again benefitted to these big investors.
  • If the 5 big investors NOT invested in the fund, the NAV might be again back to Rs.10 as the total AUM used to be back to Rs.1,000 and units 100.
  • Because of these big investors’ action of investing more during a fall, it benefitted to them the most rather than to those who just hold the investment.

Here, in the above examples, BIG investors do not mean BIG. Those investors may be YOU and ME too. Just to give an understanding of how such knee jerk reactions impact the NAV of the fund and pose a risk to those who stayed invested.

Just to avoid just panic selling, many mutual fund companies used to bring in the exit load when such default or downgrade happens. The classic example is the recent UTI AMCs exit load when the AMC faced an issue with DHFL.

Due to the low penetration of Mutual Funds in India and lack of knowledge of how the Debt Mutual Funds works, many retail investors may be unaware of such events. However, only few informed investors’ action of either withdrawal or investment may lead to a risk to these remaining retail investors.

All about Segregation or Side pocketing in Mutual Funds

In the above explanation, we understood how the knee jerk reactions by few investors may pose a risk to the investors who stayed invested. To avoid this, SEBI introduced the concept called Segregation or Side pocketing in Mutual Funds.

Segregation or Side pocketing in Mutual Funds means Mutual Fund Companies separate their bad or risky assets from their liquid assets. This creates a stoppage of sudden fall in NAV due to a few investors’ knee jerk reactions of redemption.  Few features of Segregation or Side pocketing in Mutual Funds are as below.

# You are not allowed to withdraw from the bad portfolio of a fund.

# You are allowed to withdraw and invest in a liquid portfolio.

# You will see two NAVs of a fund. One is for a bad portfolio and another is for the liquid portfolio.

# Division into two Funds (good and bad) will be effective from the date of the credit event.

# No TER or expenses will be charged on the bad portfolio. However, TER (excluding the investment and advisory fees) can be charged, on a pro-rata basis only upon recovery of the investments in a segregated portfolio.

# Any recovery in the Bad Fund (partial or full) will be distributed to the investors in the proportion of their holding in the portfolio.
# 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.
# As I told above, no redemption and subscription shall be allowed in the segregated portfolio. However, in order to facilitate exit to unitholders in the segregated portfolio, AMC shall enable listing of units of the segregated portfolio on the recognized stock exchange within 10 working days of the creation of a segregated portfolio and also enable the transfer of such units on receipt of transfer requests.
# Any recovery expenses from such a bad portfolio will be charged on such a bad portfolio. However, such legal expenses should not be more than the TER of the fund. If such recovery charges are more than TER, then AMC will bear these additional expenses.
# Mutual Fund Companies can’t charge any recovery expenses on the liquid portfolio.
# Any recovery of the amount of the security in the segregated portfolio even after the write off shall be distributed to the investors of the segregated portfolio.
Now let us take a LIVE example. Adilink Infra & Multitrading Pvt. Ltd., an infrastructure company of the Subhash Chandra-led business house, failed to repay a minority investor on Nov. 25, leading to a default.
This forced Aditya Birla Sunlife Mutual Fund company to create a segregated portfolio for three of it’s Debt Mutual Funds. The current status of these three portfolios are as below.
Birla Sunlife Mutual Fund Exposure to Adilink Infra and Multilink Trading as of 23rd Nov 2019
Let us now see how it created a Segregated Portfolio or Side pocketing to these three mutual funds by taking an example of a fund from these three.
Let us consider the example of ABSL Credit Risk Fund and the segregation will be executed as below.
Segregation or Side Pocketing in Mutual Funds
I hope now you got the clarity on how the Segregation or Side Pocketing in Mutual Fund works.

Some drawbacks of side pocketing

# As the segregation or side pocketing is allowed for risky debt portfolio, your fund manager with free hands may take certain undue risk.

# If the Mutual Fund invested in bad products, then this side pocketing will not prevent this activity completely. However, it just protects a bad event.

# Hence, I look for a regulator to act on how NOT my investment be in such defaulting or credit downgraded debt securities than acting on how to protect the LOSS after the event happening.

# Even though the segregated BAD portfolio will be listed on an exchange to sell or liquidate your holding, how many buyers will come forward to buy such a bad portfolio (downgraded or defaulted) securities? If you just go through the current yields of the bonds or NCDs issued by these downgraded or defaulted companies, they are trading at around 80% yield. This shows that there are no buyers. Hence, I don’t think listing the segregated bad portfolio on exchange will serve any purpose.

# It is too early to judge as there are certain doubts on how the mutual fund companies will impact and manage. Hence, let us hope for the best.

16 Comments

  1. Franklin UST informed about segregation in November and provided no load exit offer from Nov 25 to Dec 24. I redeemed my money in that period. But I have some questions now
    1. After this notice, is it necessary that they will do the segregation? And does the segregation happen just after Dec 24 or after some time?
    2. You mentioned that “Division into two Funds (good and bad) will be effective from the date of the credit event.” Here the ‘credit event’ is any kind of credit downgrade or downgrade to ‘below investment grade’ level. Is segregation an automated process directly linked to credit event?
    3. If I invest now, will 100% of my money go to the good part of the fund or some of it will still go to segregated portfolio. Basically is it safe to buy Franklin UST now without having any units of segregated portfolio?
    4. If I invest now and the money goes to good part of fund, will I benefit extra if Vodafone papers become investment grade and pays their debt back? Will the NAV see a good jump in value?

    Reply
    • Dear Shubham,
      1) It may or may not.
      2) It is not only with credit downgrade but also with credit default. It is not automatic. But to protect their misdeeds AMCs go for this last route.
      3) Who knows that in that GOOD portfolio if in future some other company default?
      4) I never suggest such a risky play and that also with your debt part.

      Reply
      • Thanks Basu
        So basically if any kind of credit event occurs later in FT UST, that paper will also go to the existing segregated portfolio or a new segregated portfolio will be created from the main portfolio?
        Do they notify for this segregation exercise again in future for other papers or this is once in lifetime of particular fund?

        Reply
        • Dear Shubham,
          They will create one more segregated portfolio based on the % of exposure they have in good portfolio. Yes, they will notify such segregation actions as and when there is a creation of segregation.

          Reply
          • I know that they will inform once the segregation is done. By then it is of no use for investors since investors’ money is blocked now.
            By future notification of segregation, I meant whether they will inform 1 or 2 months before and give no load exit offer if investors want to take out their money, similar to what FT UST did in Nov-Dec 2019 before the credit event happened in Jan

            Reply
  2. If redemption is not allowed in segregated portfolio, then how do we sell these? Assume 50% recovery happened in the segregated portfolio and I’m ok to take that money and forget the rest.

    Reply
    • Dear Melwyn,
      Liquidity is obviously an issue and your assumption does not work there.

      Reply
      • ok, thanks for replying. So effectively, there is no way to exit the segregated portfolio, other than to find some buyer for it on the stock exchange.

        In Budget 2020, there is some changes in the cost of acquisition calculation for the units in segregated portfolio. Specifically “The cost of acquisition of a unit or units in the segregated portfolio shall be the amount which bears, to the cost of acquisition of a unit or units held by the assessee in the total portfolio, the same proportion as the net asset value of the asset transferred to the segregated portfolio bears to the net asset value of the total portfolio immediately before the segregation of portfolios,”
        Could you explain this with an example.

        Reply
        • Dear Melwyn,
          ok, thanks for replying. So effectively, there is no way to exit the segregated portfolio, other than to find some buyer for it on the stock exchange-YES.
          It states that the date of acquisition for such a segregated portfolio and main portfolio will remain the original date of acquisition than the side pocketing date. It is a good move actually.

          Reply
          • I understood about the date of acquisition, but what I pasted from the budget refers to the “cost” of acquisition. Before the budget, the cost of acquisition would be 0 (AMC provides the segregated portfolio at 0 NAV). This is not actually right, because then I would have to pay tax on any amount recovered in the segregated portfolio. Consider a scenario where I lost a part of my principal in the main portfolio, then when it is recovered back in the segregated portfolio I’m paying tax on a profit that I did not technically make.

            This I believe is corrected in the recent budget, but I’m not clear what they are now considering as the “cost” of acquisition in the segregated portfolio.

            Reply
              • In Budget 2020, what is now considered the “cost of acquisition”? (the “date of acquisition” is clear and simple to understand). Could you explain with an example?

                Reply
                • Dear Melwyn,
                  The cost of acquisition of units are the original cost with proportionately dividing between good and bad portfolio (equally how the AMC will segregate).

                  Reply
  3. What is tax implication on investor with regard to segregated portfolio.

    Reply

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