In March 2024, SEBI Chairman Madhabi Puri Buch stated, “Investors will benefit from knowing how many days the funds would need to exit their underlying portfolio in the event of unfavorable market conditions.”
To find this period, SEBI asks Mutual Fund Companies to conduct a Stress Test.
What is a Stress Test?
In the case of pressure in the equity market and a consequent spike in investor redemptions, a stress test establishes how long (days) investors may recover their investment back. These stress tests are carried out by mutual fund companies to evaluate the liquidity of small and midcap stocks.
During the test, the Mutual Fund Company measured the speed at which a fund manager may liquidate small- and mid-sized company stocks in the event of redemption pressure. Additionally, it determined if selling these stocks would result in a large price decline or not.
What is the purpose of SEBI in conducting this Stress Test?
According to SEBI, froth is forming in these funds, and it wants to make sure that small-cap funds have the capacity to manage unforeseen redemptions. Fund houses must have adequate liquidity and a strategy in place for selling the equities, according to SEBI. This is important because small-cap & mid-cap stocks have less liquidity as compared to large-cap companies.
AMCs were requested by the Association of Mutual Funds in India (AMFI) to run stress tests on their schemes using the data from the previous month and disclose the results by 15th March 2024. They are then required to provide the numbers every fifteen days.
This Stress test is being done by calculating the time required to liquidate 50% and 25% of portfolios on a pro-rata basis after removing the bottom 20% of portfolios based on scrip liquidity.
Learnings for Retail Investors?
Investors can learn more about how their mutual fund assets would do in a volatile market by conducting stress tests. Investors may control their expectations about possible losses during market downturns and make better judgments by being aware of the possible risks and vulnerabilities in the fund’s portfolio.
Additionally, the test indicates if the equities in your portfolio are still deemed affordable or if they have reached an all-time high. The goal of the stress test is to evaluate your portfolio with the benchmark index’s Price-Earnings (PE) ratio.
How can we interpret the Result of this Stress Test?
Let’s examine the figures and determine how the stress test turned out. 25% of Nippon India Small Cap Fund’s portfolio would need to be liquidated in 13 days, and 50% would need to be sold off in 27 days. What does that signify?
- 50% of the Portfolio can be sold in 27 days: It indicates that under the stress situation, the mutual fund estimates it would take approximately 27 days. to sell off 50% of its portfolio. It means, if the fund needs to raise cash quickly by selling off assets, it can liquidate half of its holdings within this time frame.
- 25% of the Portfolio can be sold in 13 days: This part of the stress test result suggests that the mutual fund could liquidate 25% of its portfolio within 13 days approx. during the stress situation. You can also conclude that a smaller portion of the portfolio could be sold off more quickly compared to the larger portion.
The outcome sheds light on the portfolio’s liquidity profile for the mutual fund. It shows how well the fund performs in stressful situations by turning assets into cash in certain amounts of time.
This information is essential for investors to comprehend the liquidity risk associated with the fund. Increased liquidity risk may be indicated by a longer time horizon for asset sales, particularly if investors must redeem their investments amid volatile market circumstances.
Now let’s see the result of Stress Results of Different AMCs
| Small Cap Funds | Mid Cap Funds | |||
| Days to liquidate | ||||
| 25% | 50% | 25% | 50% | |
| Nippon India Mutual Fund | 13 days | 27 days | 4 days | 7 days |
| Edelweiss Mutual Fund | 2 days | 3 days | 1 days | 2 days |
| Quant Mutual Fund | 11 days | 22 days | 3 days | 6 days |
| Axis Mutual Fund | * | 28 days | * | * |
| Aditya Birla Mutual Fund | 5 days | * | 2 days | * |
| DSP Mutual Fund | 16 days | 32 days | * | * |
| HDFC Mutual Fund | * | 42 days | 12 days | 23 days |
| Franklin India Mutual Fund | 6 days | 12 days | * | * |
| Canera Robeco Mutual Fund | 6.75 days | 13.5 days | * | * |
| UTI Mutual fund | 2.15 days | 4.3 days | 2.11 days | 4.22 days |
| Kotak Mutual Fund | 17 days | 33 days | 17 days | 34 days |
| Motilal Oswal | 2 days | 3 days | 5 days | 10 days |
| Tata AMC | 18 days | 35 days | 2 days | 3 days |
| SBI Mutual Fund | 25 days | 60 days | * | * |
Certain important points we should take into consideration while jumping to the conclusions are:
- Those Mutual Funds who has larger assets under management (AUM) / larger corpus, would have lower liquidity.
- With a few exceptions, the majority of mutual funds adhered to the stated guidelines. For instance, compared to competitors with comparable AUM, Tata Small Cap Fund stated that it would need 35 days to liquidate 50% of its portfolio.
- Amongst all funds, the SBI Small Cap Mutual Fund has the lowest liquidity i.e. 60 days to liquidate 50% of its portfolio.
Also Read : Critical Role of MFDs in MF Investment
Conclusion:
Though this exercise is done to find out the liquidity, Mutual fund investors should not just consider the results of stress tests alone to make investment or redemption decisions.
This stress test is based on certain assumptions such as the calculation of Average Daily Volume in normal situations, Average Daily Volume in stressful situations, the share of volume a particular AMC will get, etc. Further, this calculation excludes 20% bottom liquid portfolio.
Mutual Fund investors can diversify their investment between different asset classes, across large, mid & small caps and also in different AMC/s for better portfolios.
Consider risk appetite, investment horizon, and goal before making any investment and redemption decisions.