UTI Credit Risk Fund recently announced the creation of a segregated portfolio (known as a side pocket in industry parlance), after the debt securities issued by Altico Capital that the scheme held were downgraded by India Ratings to below investment grade on September 13. So, if you are a unit holder in funds that resort to side-pocketing, what options do you have? Here is what you must know about side pocketing to make an informed call.
What is side pocketing?
If a security held in the portfolio of a mutual fund is downgraded by a rating agency or the issuer of the instrument defaults, the value of the exposure is reduced to reflect the new circumstances or in some cases even written off in the books of the scheme. The net asset value (NAV) of the scheme goes down as per the valuation guidelines. In order to prevent new investors from coming in at an advantageous lower valuation, the fund house suspends fresh inflows into the schemes, to protect the interests of the existing investors.
Now, to work around such a situation, side pocketing comes to rescue. Side pocketing allows the fund house to segregate the troubled securities from the good ones. The bad bonds are held in a separate portfolio. Units are issued after taking into account the amount in default and the investor’s existing holding. These units are listed on the stock exchange and the investors have the option of trading in them. New investors can invest in the ‘non-side pocketed’ part of the portfolio like in any other scheme.
When did it begin?
Securities Exchange Board of India (SEBI) allowed fund houses to go for segregated portfolios in December 2018. Even before these rules were set in place, JP Morgan AMC had decided to create a side pocket when its debt fund witnessed a default on bonds issued by Amtek auto in September 2015. After the introduction of side pocketing norms, fund houses such as Tata, Reliance and UTI have opted for it.
Is it good for investors?
It works favourably for investors in two ways. The fund house separates the two portfolios – the good debt from the bad one. This means the good portfolio continues to perform like any other mutual fund scheme. Existing and new investors can continue investing in that portfolio. There is no need to introduce any restrictions on the good portfolio in the form of suspension of subscription or steep exit load. The good portfolio need not come under redemption pressure and the fund manager can focus on investment management.
The bad portfolio, on the other hand, with the segregated units, is listed on the stock exchange. The investor has the option of holding on to them. But rarely do investors get to exit at the fair value of the unit. The fund house is expected to take reasonable actions to recover the money for the investor. As and when the amount is received, the investors holding the side-pocketed portfolio units are paid. Money recovered, partially or full, is distributed to the investors proportionate to their holdings in the segregated portfolio units.
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