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SEBI gives fund houses option to segregate bad assets; fund managers' bonuses will be cut After giving the green signal to side-pocketing, SEBI has given the option to fund houses to segregate bad assets. But there are strict conditions to prevent misuse.

Updated: Dec 28 2018 9:37PM



Debt mutual funds will now be able to segregate their portfolios and carve out bad securities. The capital market regulator, Securities and Exchange Board of India (SEBI) said, in a circular issued on 28 December, that in case where the credit rating of an instrument held by a debt fund gets downgraded to "below investment grade" (below BBB-rating) then fund houses can choose to segregate such bad securities and allow investors to continue to buy or sell the good portion of the scheme. The segregated portfolio will not allow any fresh investments.

In simple words, your holding in the scheme would be split into two; the good part and the bad part, with an equal number of units in both. You can choose to sell the good units and exit, but the bad units will be frozen until your fund recovers the dues from the bad assets. Both the good and bad (segregated) part of your scheme will have net asset values (NAV).

SEBI has given the option to fund houses to decide whether or not they want to go ahead and segregate assets. But fund houses will not be able to do this immediately. The market regulator has mandated that those fund houses who think they may use this facility need to first mention it in their Scheme Information Documents (SID).

"It would take another month and half to two months for fund houses to modify their existing SIDs to be ready for side-pocketing," said the head of operations of a fund house requesting anonymity.

Not everyone is happy with SEBI giving the option to the fund house. "This may not be fair because different fund houses will give different treatments to the same credit event. Say, there are two investors who have invested in two different funds. Both these funds invest in the same security, which now defaults. But if the first fund segregates its portfolio and the second fund doesn't, the latter's investor is worse off than the former's. Investors will be subject to different treatments," said the head of fixed income funds at a large fund house who did wish to be quoted.

R Sivakumar, head-fixed income, Axis Asset Management disagrees. "Keeping it optional is necessary because although two affected funds may have the same security, one fund could have a small allocation, say, 0.5% and the other fund can have a larger allocation, say, 5% of the portfolio. The first fund may not find it necessary to side-pocket, given the small exposure," he said.

Joydeep Sen, founder, wiseinvestor.in added, "it has to be optional and left open to fund houses to decide if they want to segregate their assets or not. We see many times, two funds with apparently similar strategy perform differently during different time periods, e.g. two large cap funds or two long bond funds. A matter of fund management strategy will vary from fund house to fund house."

Many fund houses have been clamoring to be allowed to segregate bad assets, known as side-pocketing in mutual fund (MF) parlance, ever since the Infrastructure Leasing & Financial Services Ltd (IL&FS) crisis broke out in the months of August and September 2018.

Back then, the firm and some of its subsidiaries' credit ratings were downgraded. Debt funds that had invested in these scrips got impacted. Some fund houses that had invested in these scrips took a hit as they wrote down their investments in these scrips resulting in a fall in their net asset values. Investors were caught off-guard as the net asset values (NAV) of these schemes fell overnight and those who panicked and withdrew had to do so at a loss.

To ensure that fund houses do not misuse side-pocketing -- or do it frequently -- SEBI has said that fund houses to not charge asset management (AMC) fees for the segregated portfolios. Of the total expenses that schemes can charge to investors (a maximum of 2.5 percent by equity funds and 2.25 percent by debt funds; this has undergone a revision but the final circular on expense ratios is awaited), a portion goes into the kitty of the fund house.

This is called fund management or asset management charges. Infact, the segregated portfolio cannot charge any fees (total expense ratio) until the time the fund house recovers money. Once the money is recovered by the segregated asset, only then it can charge the expenses to the tune of what the main portfolio had charged during the segregated period, but without AMC fees.

Further, the market regulator has told trustees of mutual funds segregating portfolios to penalise fund managers' compensation responsible in buying those securities in the first place. The penalised bonus must be added to the affected scheme, thereby benefiting investors.

Some grey areas remain. SEBI has said that side-pocketing can be initiated when there has been a downgrade of an instrument to "below investment grade". But what if an instrument is AAA-rated and then suddenly defaults? "Sebi has not made this clear. Ideally, Sebi should have said that it should be either downgrade or default," said a senior fund official who did not want to be quoted.

SEBI has also said the portfolios -- both the main as well as the segregated -- would be valued as per prevailing valuation norms. This means the main portfolio would see its NAV fall and subsequently the segregated portfolio will have its own separate NAV. That's fine so far. But what happens if the fund or the segregated asset to be precise, recovers its dues? Will the main portfolio's NAV go up simultaneously?

Sivakumar said that from an initial reading of SEBI's circular, it seems that just the segregated portfolio's NAV would go up, but perhaps not the main portfolios. "If that is the case, then the main scheme’s returns will be impacted for a long, long time to come, despite having recovered its dues," he pointed out.

If your fund house does indeed segregate its portfolio, you will hear about it. Right from declaring publicly its intention to segregate (on the day the event occurs) to sending text messages on mobile phones or emails informing you about the segregation and how it would impact you, SEBI has asked fund houses to keep its investors informed.

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