Side Pocketing in Mutual Funds and Segregated Portfolios
Side pocketing is the practice of carving a distressed bond out of a mutual fund scheme into a separate portfolio, called a segregated portfolio, so that the rest of the fund can carry on normally. SEBI formally allowed it through a circular in December 2018, after the default of a large infrastructure finance group froze parts of several debt schemes.
The point is fairness. Without side pocketing, investors who redeem first get out at a NAV that still values the bad paper, and whoever stays behind absorbs the loss. Segregation freezes the bad asset for everyone who owned it on the day trouble struck.
It is not a rescue. Side pocketing does not recover your money, it only stops the loss from being passed around unfairly.
What Triggers a Segregated Portfolio
The trigger is a credit event on a debt or money market instrument the scheme holds. SEBI defines it to cover an actual or potential default on interest or principal, a downgrade of the paper to below investment grade (below BBB minus for long term ratings), and any further downgrade of paper already rated below investment grade.
Two conditions matter before an AMC can act. The scheme information document must already carry an enabling provision for segregated portfolios, and the trustees have to approve. The AMC applies to the trustees on the day of the credit event, and if approval comes within one business day, segregation takes effect from the date of the credit event itself.
A rating downgrade from AA to A does not qualify. The paper has to fall below investment grade, or default, or be at real risk of default.
How Your Units Get Split
On segregation the scheme becomes two portfolios. The main portfolio holds everything healthy and keeps trading normally with daily NAV, subscriptions and redemptions. The segregated portfolio holds only the distressed paper.
Every investor on the register as on the day of the credit event receives units in the segregated portfolio, pro rata, matching the units they held in the scheme. Somebody with 10,000 units ends up with 10,000 main portfolio units and 10,000 segregated portfolio units.
What you can and cannot do with those units
- No fresh subscription into the segregated portfolio is allowed, ever.
- No redemption from it either, because there is nothing liquid to pay you from.
- The units must be listed on a recognised stock exchange within 10 working days of creation, so an investor who needs an exit can try to sell them there, usually at a steep discount.
- Anyone who buys into the scheme after the credit event gets only main portfolio units.
- The AMC has to send a statement of holding showing units and NAV of both portfolios within a few working days.
Costs, Disclosure and Recovery
SEBI bars the AMC from charging investment and advisory fees on the segregated portfolio. Only actual legal and realisation expenses, such as recovery proceedings, can be charged, and those must be disclosed.
NAV of both portfolios has to be published daily from the day of segregation. The segregated portfolio NAV usually starts at a written down value, sometimes close to zero if the recovery outlook is poor.
Recovery is paid as and when it arrives. If the borrower repays part of the dues, or a resolution plan or insolvency proceeding under the IBC yields cash, the AMC distributes it to segregated portfolio unitholders in proportion to their holding. There is no fixed timeline, and money can trickle in over several years or never arrive.
| Feature | Main portfolio | Segregated portfolio |
|---|---|---|
| Fresh subscription | Allowed | Not allowed |
| Redemption at NAV | Allowed | Not allowed |
| Exchange listing | Not applicable | Mandatory within 10 working days |
| Management fee | Charged as usual | Not permitted |
| Payout | On redemption | Only as recovery happens |
What This Means for You as an Investor
Read the risk-o-meter and the rating mix rather than the headline yield. Side pocketing is a cleanup tool for a loss that has already happened, so the real protection is avoiding concentrated low-rated exposure in the first place. A single issuer at 5% of a debt portfolio is a meaningful bet.
Also watch how the AMC behaves after a credit event. SEBI requires that segregated portfolio performance be reflected in the scheme’s disclosures, so the loss stays visible instead of quietly disappearing from the track record.
Frequently Asked Questions
Do I lose money the day a segregated portfolio is created?
The loss happens at the credit event, not at segregation. Your combined value across both portfolios equals what the scheme was worth after the distressed paper was marked down. Segregation only separates the damaged asset so future buyers and sellers are not affected by it.
Can I sell my segregated portfolio units for cash?
You cannot redeem them with the AMC, but they are listed on a stock exchange, so a buyer may take them off you. Liquidity is thin and prices are typically far below the stated NAV. Most investors simply hold and wait for recovery distributions.
Is side pocketing the same as a fund gating redemptions?
No. Restricting redemptions shuts the door on the whole scheme for a limited period under specified conditions, whereas side pocketing keeps the healthy part of the scheme fully open. They are separate tools with separate SEBI conditions.
How is recovery from a segregated portfolio taxed?
A distribution against your segregated units is treated like a redemption of those units, so capital gains rules for that scheme type apply, with the original cost apportioned between the two portfolios. Tax rules on debt schemes have changed more than once, so confirm the current treatment with your tax adviser.
Key Takeaways
- Segregated portfolios ring-fence distressed debt so early redeemers cannot pass losses to others.
- The trigger is a default, or a downgrade to below investment grade, plus trustee approval.
- Existing unitholders get pro rata units in the segregated portfolio on the credit event date.
- No subscription or redemption is allowed there, but the units are listed on an exchange.
- Recovery is distributed only as and when it is actually received.
