Franklin Templeton has become the latest fund house to offer a ‘side pocket’ to investors in its fixed-income schemes hit by ratings downgrade of debt securities issued by crisis-hit Vodafone Idea. The board of trustees of Franklin Templeton Mutual Fund (MF) has approved the creation of ‘segregated portfolio’ or a side pocket in six of its fixed income schemes— Franklin India Credit Risk Fund, Franklin India Short Term Income Plan, Franklin India Ultra Short Bond Fund and Franklin India Income Opportunities Fund.
With effect from 24 January, various securities issued by Vodafone Idea, in the abovementioned schemes, will be segregated from the total portfolio. “This decision has been taken in order to protect value for existing unitholders in these schemes. These securities have already been marked down by us to a value of zero, on January 16,” Franklin Templeton MF said.
While side pocketing is in vogue in several developed economies, markets regulator Sebi allowed it in debt schemes of MFs only in January last year. Tata MF was the first fund house offer a ‘side pocket’ to investors in the country by segregating the portfolio of securities of crisis-hit mortgage lender DHFL held by its debt schemes last June.
So how does a side pocket work? The side pocket is generally formed by the creation of a separate portfolio of distressed, illiquid and hard-to-value assets. Each investor is allocated his/her pro-rata interest in the side pocketed portfolio. To put it simply, side pocketing removes the bad apples from the good ones.
In case of credit events, existing investors potentially lose all value if there is no side pocket. With side pockets, investors, who take the hit when the credit event happens, get the full upside of a future recovery. When recovery is made in the side pocketed portfolio, the same is distributed among investors on a pro-rata basis.
What impact does it have on investors? You cannot subscribe or redeem (exit) your units in a side pocket portfolio. The fund house would transfer the money to the investor in the segregated portfolio of the troubled investment (for example DHFL, Vodafone Idea) when the debt security matures.
You can also get money if the fund house is able to sell the troubled securities after an upgrade from credit rating agencies. Typically, an upgrade would result in an improvement in liquidity for the troubled investment offering a window of opportunity to exit.
Personal finance experts say that ‘side pocket’ is a useful tool for investors. In the absence of a side pocket, there would be huge redemption pressure. The fund house would have to sell good quality securities to meet redemption requirements.
How would the portfolio look like after a side pocket is created? The number of MF units in both the side pocketed and the regular portfolios would be shown as the same. However, the net asset value (NAV) of the portfolios would be different. In the case of the fixed income schemes of Franklin Templeton MF that have taken a hit—the exposure to the downgraded securities of Vodafone India was 4.1-6.5 percent of their respective total AUM.
A statement of account indicating units held by the investors in the main and segregated portfolio along with the respective NAVs as on the day of the credit event will be communicated to the investors within five working days of the creation of the segregated portfolio.
Though units of the segregated portfolio will not be available for subscription or redemption, the AMC (asset management company) will enable listing of units of the segregated portfolio on the recognised stock exchange within 10 working days of the creation of the segregated portfolio and enable the transfer of such units on receipt of transfer requests.
Upon recovery of money from the issuer in the segregated portfolio, whether partial or full, it will be distributed to the investors in proportion to their holding in the segregated portfolio. No investment and advisory fees can be charged by the AMC on the side pocketed portfolio.
However, TER or total expenses ratio (excluding the investment and advisory fees) can be charged on the side pocketed portfolio but only upon recovery, on a pro-rata basis i.e. on the recovered amount. Franklin Templeton MF has restricted fresh inflows in these schemes to Rs 2 lakh per day per fund per investor, till further notice. This limit is imposed only on the new applications received after the cut-off time on January 16.
Allirajan M is a journalist based in Coimbatore.