NAV, TER and Pricing in Segregated Portfolios
Definition
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.
In Simple Words
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.
Real-Life Scenario
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: Before side-pocketing: • NAV: ₹25.00 (includes Vi bonds at original value) • After MTM markdown of Vi bonds: NAV would have dropped to ₹23.75 (5% fall) After side-pocketing: • Main Portfolio NAV: ₹23.75 (reflecting the value of all good assets only) • Segregated Portfolio NAV: ₹1.25 per unit (reflecting the impaired Vi bonds valued at 25% of face value) 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.
Key Points to Remember
Frequently Asked Questions
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Side-pocketing (segregated portfolio) in mutual funds was introduced by SEBI in:
Summary Notes
Side-pocketing (segregated portfolio) was introduced by SEBI in December 2018 to protect debt fund investors from unfair impact of credit events — the IL&FS crisis was the trigger
When invoked, the distressed security is separated into a segregated portfolio with its own NAV, while the main portfolio continues normally — existing investors get units in both
New investors can only invest in the main portfolio and have no claim on the segregated portfolio or its recovery proceeds
TER on the segregated portfolio cannot exceed the main portfolio TER — and SEBI allows AMCs to list segregated units on exchanges for investor liquidity
The Franklin Templeton crisis (April 2020) was a different event (scheme winding up, not side-pocketing) but highlighted the importance of credit risk management in debt funds