What, why and how of side pocketing

Segregation of portfolio treats all unitholders alike

A few friends went out for a meal and ordered a veg platter. None of them like broccoli.

However, when the platter arrived, it had broccoli. Each person, before passing the platter to the next one, is careful to serve themselves other vegetables except broccoli.

What is the last person most likely to find on the platter by the time it comes to him; a plate full of broccolis!

Ditto for a fund with a stressed asset. If redemptions in a fund continue unabated, the stressed asset in a portfolio keeps increasing in size and the unit holders who are left in the fund bear the burden disproportionately.

This happens because the investors who leave early get paid from the liquid/high quality assets part of the portfolio and, slowly, as the fund size shrinks, it becomes more and more toxic and the concentration of such an asset increases.

How it works

Segregation of portfolio addresses this anomaly by treating all existing unit holders alike. The scheme is split into two parts — main portfolio and segregated portfolio. Existing unitholders get units in both portfolios. If someone wishes to redeem, they will be able to do so from the main portfolio but not from the segregated one. The segregated portfolio will trigger payouts automatically if and when there is cashflow.

Earlier this year, SEBI introduced segregation of portfolio in MFs. For a mutual fund to be able to do side pocketing, it was required to introduce this feature in its scheme as a fundamental attribute change. The scheme must give an option to unitholders to redeem without any load within the next 30 days from the time of introduction of the attribute change.

If a fund enabled with this feature has a credit event, leading to the security getting rated as D, then the fund can invoke segregation of portfolios. The AMC is required to immediately suspend subscriptions into the fund and within a stipulated period the portfolios must be segregated, unit creation must be made for segregated portfolio and main portfolio.

Being fair

We at Tata MF enabled this in some of our funds. When the DHFL bond defaulted its payment in some of our schemes that held those bonds, we decided to side pocket DHFL in three of our funds, namely, Tata Treasury Advantage, Tata Corporate bond fund, and Tata Medium term fund. Staying invested is a virtue in the investing world and we believe by doing so, the last unit holder should not be disadvantaged and, hence, side pocketing was required. Being rid of the toxic asset from the main portfolio, it behaves like any other fund and regular inflow and outflow keeps the scheme vibrant. The key advantage is that anyone who wishes to redeem gets his/her proportionate share of the main portfolio and is not unduly benefitted compared to investors staying back in the scheme. Mutual funds are pass through vehicles, but how this happens is as important as what you pass through.

The writer is Business Head – Banking, Alternate Products & Product Strategy, Tata Asset Management Ltd

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