Side Pocketing or Segregated Portfolios in Debt Funds

There has been a lot of chatter currently on news channels and various other sources regarding this Side Pocketing or Segregated Portfolios in Debt Fund. Let’s understand what this exactly is.

In the last 3 to 4 months lot of defaults have started happening esp. due to NBFC crisis. In fact, lot of downgrades have happened in the last 1 year. Because of these downgrades or these credit events, a lot of debt funds have gone down on their NAV’s particularly. This has never been seen before. Earlier it could be seen that these debt funds (like credit funds and accrual-based funds) would keep growing slowly and continuously. And people were comparing these debt funds with fixed deposits. But they were only comparing it on the returns part or the taxation part and not on the risk factors involved in that.

Now, SEBI has allowed these debt funds to have segregated portfolios.

Let’s understand what segregated portfolios are,

For example, assume that a fund’s NAV is Rs. 50. And in this Rs. 50, investment papers worth Rs. 2.50 have been downgraded or default has happened. Normally, if the fund has to take a hit, then the NAV would go down to Rs. 47.50. The fund was holding the Rs. 2.50 as well, but AMFI reported the NAV as Rs. 47.50. In this case, investors thought that their investment has gone down from Rs. 50 to Rs. 47.50 and they will never get back the amount of Rs. 2.5, so it is kind of a booked loss for them.

And suppose that after a year the downgraded company gets a revival and is able to repay the money to the fund. Thus, the investors of the fund at that time will get the benefit of the Rs. 2.50. So, the investors who suffered when the NAV became Rs. 47.50 will never get back their money.

Therefore, to avoid this, SEBI has allowed this kind of debt funds to segregate these portfolios. In such a case, a fund A (assume the name just for example) having NAV of Rs. 50 will now have NAV of Rs. 47.50. And SEBI will now allow them to segregate the portfolio calling it as Fund A1 (assume the name just for example) with the NAV Rs. 2.50. So, now the investor will get equal number of units of fund A1 as of fund A. The investor will be allocated will the corresponding number of units if the investor has invested in that fund at the time of default. Thus, if and when that money comes back, the investors will get back their investments. And if an investor exits without segregated portfolios, then the investor books that Rs. 2.50 as loss, which is not a good idea.

Need for Side Pocketing or Segregated Portfolios in Debt Fund

In the last 3 to 4 years a lot of fixed deposit investors have shifted to debt funds expecting similar and steady returns from these debt funds, which is not happening in the past 1 and half years because of the defaults and also because of the interest rates going up.

When the NAV’s of debt funds go down because of defaults, the retail investors panic and exit these funds. But this is not the right action to take.

Therefore, to safeguard the investors SEBI has allowed debt funds (or money market funds) to segregate these portfolios or side pocket these portfolios and allocate additional units in the new fund. Hence, the investors in this fund will have some hope that the money lost will come back to them only.

So now, even if the investors exit, they exit with NAV of Rs. 47.50 and have the rest of Rs. 2.50 as a segregated portfolio and get that money back if and when the recovery happens.

Thus, side pocketing or segregated portfolio in debt funds is fair to all deal, a win-win situation for everyone. Therefore, this a very good step taken by SEBI.