Segregated Portfolio Mutual Fund: How a Side Pocket Works

A debt fund can look boring for years and then, in one afternoon, a rating agency cuts one issuer to junk and everything changes. The fund now holds paper nobody wants to buy, a few investors rush for the exit, and the ones who stay quietly carry the bad bond. A segregated portfolio mutual fund structure, which most of us know as a side pocket, is SEBI’s answer to exactly that mess. It splits the damaged bond away from the rest of the scheme so that the healthy part keeps working and the stuck part waits for recovery.

This guide walks through what the rules actually say, how the units and NAV split on the day of the credit event, how fees are handled, and what it means for you as a unitholder. We’ll use a made-up scheme with round numbers so the arithmetic is easy to follow. The rules quoted here come straight from SEBI’s two circulars on the subject, linked at the end.

What a segregated portfolio mutual fund setup means

SEBI first allowed side pockets through its circular of December 28, 2018. The stated purpose was “to ensure fair treatment to all investors in case of a credit event and to deal with liquidity risk.” The circular defines three terms, and they are worth getting straight:

• Segregated portfolio: the debt or money market instrument hit by the credit event, carved out of the scheme.
• Main portfolio: everything else in the scheme.
• Total portfolio: the scheme as it was, including the troubled paper.

So nothing is sold or moved to a new fund house. The same scheme simply runs two books from the day of the credit event: one you can trade in normally, and one that is frozen until money comes back.

When a fund house is allowed to side-pocket

The trigger is narrow on purpose. Under the 2018 circular, a credit event means a downgrade by a SEBI-registered credit rating agency, at the issuer level, of one of these kinds:

• a debt or money market instrument downgraded to below investment grade,
• further downgrades of such an instrument once it is already below investment grade, or
• similar downgrades of a loan rating.

If two or more agencies rate the paper differently, the most conservative rating counts. The decision is taken at the issuer level but carried out ISIN by ISIN, so every affected security of that issuer is handled individually.

There was a gap in this design. Plenty of corporate paper held by debt funds is unrated, and an unrated bond can’t be downgraded. SEBI closed that gap with a follow-up circular dated November 7, 2019. It allows a side pocket for unrated debt or money market instruments of an issuer that has no outstanding rated debt, but only on an actual default of interest or principal. A rating cut won’t do here; the issuer has to miss a payment. Business Standard quoted a fund manager at the time saying there “was a grey area on unrated debt exposure” before this change.

The November 2019 circular added a fairness step too. The fund house that spots the default has to tell AMFI immediately, and AMFI has to pass it on to all AMCs. Only after AMFI spreads the word can fund houses segregate. That stops one AMC from quietly using early knowledge of a default to its own advantage.

It’s optional, and the scheme document has to allow it

A side pocket is never automatic. The 2018 circular says creating one is “optional and at the discretion of the AMC”, and it can only be done if the scheme information document (SID) already has provisions for it with proper disclosures. The AMC also needs a written policy on segregation approved by its trustees.

The 2019 circular tightened this for the future: every new scheme launched after November 7, 2019 has to carry the enabling provision in its SID. For older schemes, the AMC has to add the disclosures to the SID first, subject to Regulation 18(15A) of the SEBI (Mutual Funds) Regulations, 1996.

A side pocket doesn’t make a bad bond any better. It just makes sure the people who owned the fund when the bond went bad are the ones who share its fate, recovery included.

How the split happens, step by step

The circular lays out a tight timeline. Here is the sequence in plain words:

1. Day of the credit event: the AMC decides whether to segregate. If yes, it seeks trustee approval and immediately issues a press release saying it intends to segregate, what that means for investors, and that it is subject to trustee approval. The release has to sit prominently on the AMC’s website.
2. Until trustees approve: subscriptions and redemptions in the scheme are suspended for processing. This pause can’t last more than one business day from the credit event.
3. Once trustees approve: the segregated portfolio takes effect from the day of the credit event. The AMC puts out another press release with full details, sends the information to SEBI, and emails or texts every unitholder of the scheme.
4. Units and NAV: NAVs of both the main and segregated portfolios are disclosed from the day of the credit event. Every investor holding units that day gets the same number of units in the segregated portfolio as they hold in the main one.
5. Exit route: you can’t redeem or buy units of the segregated portfolio. To give holders some way out, the AMC has to get those units listed on a recognised stock exchange within 10 working days and allow transfers.

If the trustees say no, the AMC has to announce that immediately, and all buying and selling goes through at the NAV of the total portfolio as before.

One point people often miss: segregation does not mean the bad bond escapes a markdown. The circular says the valuation must still take the credit event into account and follow fair valuation principles, which it describes as the realisable value of the assets. The side pocket decides who owns the loss. It does not hide it.

A worked example with a made-up scheme

Let’s take a hypothetical debt scheme. All numbers below are invented for illustration.

• Total portfolio value before the downgrade: ₹1,000 crore
• Units outstanding: 50 crore, so NAV is ₹20.00
• Exposure to Company X bonds: ₹50 crore, or 5% of the portfolio

Company X gets downgraded to below investment grade. Following fair valuation, the fund marks the Company X bonds down from ₹50 crore to, say, ₹15 crore. The total portfolio is now worth ₹965 crore.

Notice that ₹19.00 plus ₹0.30 equals ₹19.30. On day one, nobody gains or loses value from the split itself. What changes is what you can do with each piece.

Say you hold 10,000 units. Before the downgrade they were worth ₹2,00,000. After the split you hold 10,000 main units worth ₹1,90,000, which you can redeem normally, plus 10,000 segregated units carried at ₹3,000, which you can’t redeem but can sell on the exchange if there is a buyer.

Under the circular, if you redeem after trustee approval, you get the main portfolio NAV and keep your segregated units. A new investor who buys in after the split gets units only in the main portfolio, at its NAV of ₹19.00.

What happens on recovery

Now suppose that a year later Company X pays back ₹40 crore. The circular says any recovery, partial or full, has to be distributed immediately to segregated unitholders in proportion to their holdings, even if the paper had already been written off. ₹40 crore spread over 50 crore segregated units is ₹0.80 per unit, so your 10,000 units bring in ₹8,000.

Why this is fairer than doing nothing

Run the same story without a side pocket. The day after the downgrade, nervous holders of 10 crore units redeem at ₹19.30 and walk away with ₹193 crore. The fund pays them out of its good, liquid bonds, because nobody is buying Company X paper. The remaining 40 crore units now sit on ₹772 crore of assets, and the ₹15 crore of bad paper has grown from about 1.55% of the fund to about 1.94%. Those who stayed now carry a bigger share of the problem.

Then the ₹40 crore recovery arrives. The fund’s assets go up by ₹25 crore (the bond was carried at ₹15 crore and realised ₹40 crore), to ₹797 crore, and the NAV becomes about ₹19.93. The people who left early got ₹19.30 and miss the recovery entirely. Anyone who bought in after the downgrade at ₹19.30 enjoys a windfall from a bond they never really paid for.

With the side pocket, each holder on the day of the event gets ₹19.00 from the main book plus ₹0.80 on recovery, or ₹19.80 in total, whether they left early or stayed. Early exits don’t dump the problem on others, and late entrants don’t get a free ride. That’s the whole point.

Without a side pocket, the fastest seller wins. With one, timing your exit around a downgrade stops being an edge.

Fees, disclosures and the fund manager’s skin in the game

SEBI clearly worried that side pockets could become a dumping ground or a way to earn fees on dead assets. The circular deals with that in a few ways.

Expenses. The AMC can’t charge investment and advisory fees on the segregated portfolio at all. Other expenses within the total expense ratio (TER) can be charged only on recovery, on a pro-rata basis, and they can’t exceed the simple average of the daily TER (excluding advisory fees) charged on the main portfolio while the side pocket existed. Legal costs of chasing recovery can be charged to the segregated portfolio in proportion to what is recovered, but within the main portfolio’s maximum TER; anything above that is borne by the AMC. Costs of the side pocket can never be charged to the main portfolio. If expense ratios are new to you, our explainer on the mutual fund expense ratio covers the basics.

Disclosure. Within 5 working days of creating the side pocket, investors must get a statement showing their segregated units and the NAVs of both portfolios as on the credit event date. The segregated NAV is declared daily. The number of side pockets in a scheme has to appear prominently under the scheme’s name in the SID, the KIM-cum-application form, ads and the AMC and AMFI websites. Scheme performance has to show the NAV fall caused by the segregation, with any recoveries in a footnote, and these disclosures continue for at least 3 years after the paper is fully recovered or written off.

Accountability. Trustees must make sure the AMC puts in sincere efforts to recover the money, and an action taken report on recovery goes to every trustee meeting until the matter closes. The trustees also have to have a mechanism that hits the performance incentives of the fund managers and CIOs involved in buying that paper, including clawing that money back into the segregated portfolio. And the circular says plainly that the existence of side pockets should not encourage AMCs to take undue credit risk, warning of stringent action for misuse.

What it means for you as an investor

A few practical takeaways, from where we sit:

• Check the scheme name and factsheet. Because the count of segregated portfolios has to appear prominently under the scheme name, it’s easy to see whether a fund has had trouble before. A side pocket in the history tells you something about the manager’s credit calls.
• Read returns carefully. Performance figures must reflect the NAV hit from segregation. Don’t compare a fund’s main-portfolio NAV alone with a peer that never had a side pocket.
• Don’t panic-redeem the main book. Once a side pocket is created, redeeming the main portfolio doesn’t hand your share of the bad bond to anyone else. You keep the segregated units either way.
• Expect the segregated units to be illiquid. They are listed, but listing doesn’t guarantee a buyer at a fair price. Treat them as a lottery ticket on recovery, valued conservatively.
• Remember taxes and exit loads still apply to the main units as per the scheme’s terms. Our piece on exit load in mutual funds explains how that charge works.

Side pockets also remind us that “safe” debt funds carry credit risk. If you hold debt funds for stability, it pays to look at the credit quality of the portfolio, not just the yield. Lower-credit-risk options such as a floater fund holding high-grade paper behave differently from credit-heavy schemes. And the general discipline of sizing exposure to what you can afford to lose, covered in our guide to risk management in trading, applies to fixed income as much as to stocks.

Common misreadings

• “The side pocket protects me from the loss.” It doesn’t. The bad paper is still marked down. You still own your share; you just can’t redeem it until it’s recovered.
• “Any bad news allows segregation.” No. For rated paper it needs a downgrade to below investment grade (or further downgrades from there). For unrated paper of an issuer without rated debt, it needs an actual default.
• “Every fund must side-pocket.” No. It’s at the AMC’s discretion and needs the SID provision plus trustee approval.
• “New investors share in a recovery.” Not if they came in after the split. They get only main portfolio units.

The side pocket is one of those rules that sounds technical but is really about fairness among investors in the same scheme. When a debt fund you own announces one, the right reaction is usually calm: check how big the segregated slice is, see what the main portfolio NAV looks like, and decide about the main units on their own merits.

Sources

• SEBI circular SEBI/HO/IMD/DF2/CIR/P/2018/160, December 28, 2018: Creation of segregated portfolio in mutual fund schemes
• SEBI circular SEBI/HO/IMD/DF2/CIR/P/2019/127, November 7, 2019: Creation of segregated portfolio in mutual fund schemes
• Business Standard: Sebi says mutual funds can use ‘side-pocket’ for unrated debt

Disclaimer: This article is for information and education only and is not investment advice. Mutual fund investments are subject to market risks; read all scheme-related documents carefully. Please consult a SEBI-registered adviser before making any investment decision.