What is Side Pocketing in Mutual Funds?
‘Side pocket’ refers to a segregated portfolio in a mutual fund scheme with specific securities that have been affected by a credit event. SEBI (Securities & Exchange Board of India) had, in December 2018, allowed the Mutual Funds to create Segregated Portfolios concerning debt and money market instruments as a measure to protect the interest of the investors in debt funds. Let us discuss side pocketing in mutual funds in detail below.
Why is Side Pocketing Needed?
In case of any downgrade in the credit rating to below investment grade or even lower, SEBI Guidelines require the mutual funds to appropriately adjust the valuation of debt securities in the mutual fund scheme. However, such markdown may reverse in the future, as and when recovery happens. Given the timing difference, there remains a possibility that the investors who bear the impact of markdown in the valuation may redeem at a later stage, and a different set of investors may enjoy the fruits of recovery in the form of appreciation in NAV (Net Asset Value). As such, the new investors could enjoy better returns at the expense of the earlier investors.
For example, a mutual fund scheme may have a 10% portfolio in the bonds of Company A, which has defaulted on the payment of interest on such bonds. As such, the bonds must be marked down at the time of default based on the haircut matrix given by AMFI depending on rating and type of industry of the issuer company. This will mean that the NAV will fall by such proportion immediately, assuming there was no markdown on the valuation earlier. Further, it may be assumed that six months later, full recovery happens in respect of such bonds. Such recovery will push the NAV higher immediately, which will benefit only the investors as on that date, even if they may or may not have suffered the markdown in the valuation of such bonds.
This is where the side pocketing comes into the picture, as it seeks to segregate such exposure from the main scheme portfolio, and the complete recovery from the segregated portfolio belongs to the unitholders of such a segregated portfolio. Continuing with the above example, if the portfolio has been side pocketed earlier, the recovery in such a portfolio will only accrue to the holders of the segregated portfolio.
How can Mutual Funds Create a Segregated Portfolio?
The mutual funds must decide on the creation of a segregated portfolio on the day of a credit event, and the trustee approval is required to be taken within one working day of this. Upon receipt of such approval, an equal number of the units of the segregated portfolio are allotted to all the existing investors as on the day of credit event. Further, the NAV of both the segregated and main portfolio is disclosed from the day of the credit event and
The Net Asset Value (NAV) of the segregated portfolio needs to be declared daily along with adequate disclosure of the segregated portfolio in all scheme related documents, in monthly and half-yearly portfolio disclosures. Once the segregated portfolio has been created, no redemption shall be allowed in the segregated portfolio to the investors. However, the side pockets are required to be listed on the recognized stock exchange within ten working days of the creation of a segregated portfolio to provide liquidity to the investors in respect of such units of the segregated portfolio.
Is it compulsory creating side pockets in Mutual fund?
Investors must note that side pocketing is an option vested in the hands of the mutual fund schemes, which can be triggered only at the time of a credit event. The mutual funds may create side pockets in the interest of the investors if such a credit event has significantly impacted the scheme. This ensures that any future recovery in the segregated portfolio benefits the unitholders of the segregated portfolio only. The mutual fund cannot create any new units of the segregated portfolio, and all the purchase transactions in the mutual fund scheme will be based on the non-segregated portfolio.
Taxation of Segregated Portfolio
While the investor may have invested in the debt fund earlier and the units of the segregated portfolio may be received at a later stage, Union Budget 2020 has proposed that the period of holding for the units of the segregated portfolio will be reckoned from the date of the original investment. Further, the original cost of investment will also be allocated between the main portfolio and the segregated portfolio in the same ratio as the NAV of the main portfolio and segregated portfolio immediately before the happening of the credit event.
Note: The tax benefits as mentioned in the article are for illustrative purposes only, and are updated as per Finance Bill, 2020 tabled in the Parliament and may be subject to change/ amendments at the time of passing the Bill by the Parliament/ President. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption and not on the date of investment.