SEBI announces measures to protect investors in an event of credit default

Fund managers handling debt schemes whose portfolio gets segregated because of a blundered investment call, will have to forgo a portion of their annual bonus, while mutual funds will not be able to charge fees for managing the separated part of the product. These, among a raft of measures on segregation of debt portfolio, were announced by Securities and Exchange Board of India on Friday to protect investors in these products in the event of a credit default that led to erosion of scheme returns.

The capital market regulator said the move to penalize the fund manager is to deter the fund houses from misusing this facility.

"In order to avoid mis-use of segregated portfolio, trustees shall ensure to have a mechanism in place to negatively impact the performance incentives of fund managers, chief investment officers (CIOs), etc. involved in the investment process of securities under the segregated portfolio, mirroring the existing mechanism for performance incentives of the AMC(asset management company),including claw back of such amount to the segregated portfolio of the scheme," Sebi said in a circular.


Creation of segregated portfolio is a mechanism to separate distressed, illiquid assets from other more liquid assets in a mutual fund portfolio to deal with a situation arising due to a credit event. The move comes in the wake of defaults by IL&FS that led to erosion of NAVs of various debt schemes. The NAVs of some schemes because of defaults or ratings downgrades have fallen by 3%-6% on a single day, which is roughly 50-75% of the annual return of some bond schemes.
With a segregated portfolio,investors would benefit in the event of recovery from the defaulting company.

The regulator said fund houses also cannot charge investment and advisory fees on the segregated portfolio. However, total expense ratio--the annual fee mutual funds charge investors to manage the fund-- excluding the investment and advisory fees can be charged, on a pro-rata basis only upon recovery of the investments in segregated portfolio.

Sebi said the legal charges related to recovery of the investment of the segregated portfolio should be within the maximum total expense ratio limit applicable to the main portfolio.The legal charges in excess of this,would have to be borne by the fund house.

"The costs related to segregated portfolio shall in no case be charged to the main portfolio," Sebi said.

On December 12, the Sebi board approved the proposal to allow mutual funds to create segregated portfolios with respect to debt and money market instruments.Creating segregated portfolio is optional for mutual funds, but requires trustee approval.

If investors want to redeem their units from the scheme, they would get redemption proceeds based on the net asset value of main portfolio and would continue to hold the units of segregated portfolio.

If trustees don't approve the proposal of segregated portfolio,then subscription and redemption applications would be processed based on the net asset value of total portfolio.

Fund house would have to disclose about the segregated portfolio in all scheme related documents. They would also have to provide a status update to investors at the time of recovery and also at the time of writing-off of the segregated securities.

"The existence of the provisions for segregated portfolio should not encourage the AMCs to take undue credit risk in the scheme portfolio. Any mis-use of the provisions of segregated portfolio, would be considered serious and stringent action may be taken," the regulator said.