Sebi clarifies on use of segregated portfolio by mutual fund industry

The Securities and Exchange Board of India (Sebi) on Friday issued a detailed circular on the segregated portfolio, which can be used by fund houses if debt assets are downgraded to below investment grade.

The mutual fund (MF) industry had raised a demand for such a mechanism as instruments below investment grade are highly illiquid.

However, Sebi indicated it doesn’t want the mechanism to become a norm. It said trustees need to put in place a mechanism that negatively impacts the performance incentives of fund managers and chief investment officers involved in the investment process of the segregated assets. The mechanism could even involve clawing back of such amounts to the segregated portfolio of the scheme.

Sebi stated that the option of segregated portfolio should not encourage fund houses to take undue credit risks; any mis-use could warrant stringent action by the regulator.

The circular said, “Segregated portfolio may be created in case of downgrade of a debt or money market instrument to ‘below investment grade’, or subsequent downgrades of the said instruments from ‘below investment grade’, or similar such downgrades of a loan rating.”

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In case of a difference in the rating by multiple agencies, the most conservative one would be considered.

Also, schemes would only be allowed to create such portfolios if the scheme information document (SID) explicitly states the provisions with adequate disclosures. Sebi also laid down the procedure that would need to be followed by the fund houses.

They need to decide on the creation of a segregated portfolio on the day of a credit event. Once a firm decides to create such a portfolio, it needs approval of the trustees. It also needs to communicate to investors, informing them about its intent to create such a portfolio and how it could impact them.

Till trustee approval is received – which cannot exceed more than one business day from the credit event – the scheme will be closed for processing of subscription and redemption. Once the fund house receives trustees’ clearance, the segregated portfolio would be effective from the day of the credit event.

All existing investors in the scheme on the day of the credit event will get equal number of units in the segregated portfolio as those held in the unexposed portfolio.

While no redemption or subscription would be allowed in the segregated portfolio, fund houses would need to list units of this portfolio on exchanges to facilitate exit. They would also need to enable transfer of such units on receipt of requests.

The segregated portfolio’s valuation would need to take into account the credit event and be valued on the principles of fair valuation (i.e. realisable value of the assets). The relevant provisions of Sebi (Mutual Funds) Regulations, 1996, and other related norms laid down by the regulator would also be applicable.

In case trustees’ turn down the proposal, subscription and redemptions will be processed on the basis of net asset value (NAV) of the entire portfolio.

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Fund houses will not be allowed to charge investment and advisory fees on the segregated portfolio. However, the total expense ratio (excluding investment and advisory fees) can be charged on a pro-rata basis only upon recovery of investments in the segregated portfolio.

The trustees would also need to monitor a fund house’s efforts to recover investments of the segregated portfolio. All recoveries would be distributed to the investors in proportion of their holding in the segregated portfolio.