NAV, TER and Pricing in Segregated Portfolios
A segregated portfolio (commonly known as side-pocketing) is a mechanism introduced by SEBI in December 2018 that allows mutual fund schemes to separate distres...
NAV, TER and Pricing in Segregated Portfolios
A segregated portfolio (commonly known as side-pocketing) is a mechanism introduced by SEBI in December 2018 that allows mutual fund schemes to separate distressed or impaired debt securities from the main portfolio following a credit event such as a rating downgrade to below-investment grade or actual default. When a credit event occurs, the affected security is moved to a separate "segregated portfolio" with its own NAV, while the remaining "main portfolio" continues with its own NAV. Existing investors receive units in both portfolios in proportion to their holdings. The TER on the segregated portfolio cannot exceed the TER being charged on the main portfolio. This mechanism protects existing investors from panic redemptions and ensures that any future recovery on the distressed asset benefits the original investors, not new investors.
Side-pocketing is one of the most important investor protection mechanisms in debt mutual funds, and the Franklin Templeton crisis of April 2020 brought it into the national spotlight. Understanding why it was needed and how it works is essential. Before SEBI introduced side-pocketing, the following would happen during a credit event: suppose a debt fund held 5% of its portfolio in Company X bonds. Company X defaults. The fund must immediately mark down the value of Company X bonds (MTM), causing a sharp NAV drop — say 5%. Panic-stricken investors start redeeming. The fund sells its good, liquid bonds to pay redemptions, leaving the remaining investors stuck with a portfolio that has a higher proportion of the bad Company X bonds. The first redeemers escape with relatively less damage, while loyal long-term investors suffer the most. This is deeply unfair. Side-pocketing solves this by separating the bad asset. The moment a credit event occurs, the fund creates two portfolios: (1) Main Portfolio — contains all good assets, gets its own NAV, and is open for subscriptions and redemptions as usual. (2) Segregated Portfolio — contains only the distressed security, gets its own NAV (which reflects the impaired value), and is locked — no new subscriptions or redemptions until recovery or write-off. All existing investors get units in both portfolios in proportion to their original holdings. New investors who come after the segregation can only invest in the main portfolio. If Company X eventually recovers (pays back some or all of the money), that recovery goes to the segregated portfolio investors — the unitholders who were holding when the crisis happened. This is fair and equitable.
A Practical Example
The most prominent Indian example is the Vodafone Idea (Vi) exposure in several debt mutual funds. In late 2019, after the Supreme Court's AGR ruling, Vodafone Idea's creditworthiness deteriorated sharply. Several fund houses that held Vodafone Idea bonds used side-pocketing:
Consider "Trustner Corporate Bond Fund" (hypothetical but based on real scenarios) with AUM of ₹2,000 crores and NAV of ₹25.00.
• The fund held ₹100 crores in Vodafone Idea bonds (5% of portfolio)
• After the credit event, CRISIL downgraded Vi bonds to D (default)
• The fund invokes side-pocketing:
Gopal, a retired banker from Nagpur, held 40,000 units. After side-pocketing:
• He holds 40,000 units of the main portfolio at NAV ₹23.75 = ₹9,50,000
• He also holds 40,000 units of the segregated portfolio at NAV ₹1.25 = ₹50,000
• Total value = ₹10,00,000 (same as his original investment value before markdown)
Gopal can continue to redeem from the main portfolio normally. The segregated portfolio is locked. If Vodafone Idea eventually recovers and pays 50% of its dues, Gopal's segregated portfolio NAV rises from ₹1.25 to ₹2.50, and he recovers an additional ₹50,000.
What Makes This Important
Frequently Asked Questions
No. An AMC can only invoke side-pocketing if the scheme's SID (Scheme Information Document) already contains a provision for it. If the SID does not mention side-pocketing, the AMC cannot use this mechanism. The decision to invoke side-pocketing is taken by the AMC's trustees, and SEBI and investors must be notified within one business day. The AMC's internal credit risk assessment committee evaluates the credit event before recommending side-pocketing.
🧠 Quick Quiz
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