All you need to know about SEBI's Mutual Fund Stress Test

We recently covered an article on small and midcap rallies and why market regulators are concerned about them. You can check it out here. We informed you that one of the measures the regulator is taking is the mutual fund stress test. We know it would be new for most of you - so we thought to explain it to you and then give you the numbers to understand the significance of the result's outcome.

What is a stress test?

A stress test determines the time within which you (investor) can recover your investment in the event of a downturn in the equity market and a subsequent surge in investor redemptions. Mutual fund companies conduct these stress tests to assess the liquidity of small and midcap portfolios.

As part of the test, they check how quickly a fund manager can sell small and mid-company stocks if many investors put in requests to redeem their units. It also tests what would be the price impact - whether selling these stocks would bring down their price significantly or not.

Why has SEBI asked fund houses to do this test?

As explained in our earlier article, SEBI believes that froth is building into these funds, and wants to ensure that small-cap funds can handle unexpected redemptions. SEBI wants to ensure that fund houses have enough liquidity and a plan in place to sell the stocks.

The Association of Mutual Funds in India (AMFI) had asked AMCs to conduct stress tests on their schemes based on last month's data and disclose the findings before March 15. After this, they have to disclose the numbers every 15 days.

What is the importance of stress tests for investors?

Stress tests provide investors with insights into how their mutual fund investments might perform under adverse market conditions. By understanding the potential risks and vulnerabilities in the fund's portfolio, investors can make more informed decisions and manage their expectations regarding potential losses during market downturns.

The test also tells you whether the stocks in your fund have run high or are still considered reasonable. The stress test seeks to compare the benchmark index Price-Earnings (PE) ratio against your portfolio.

Understanding the Result

Let us take the numbers and understand the outcome of the stress test. Nippon India Small Cap Fund said it would require 27 days to sell off 50% of its portfolio and 13 days to liquidate 25% of its portfolio. What does it mean?

• 27 days to sell off 50% of the portfolio: It indicates that under the stress scenario, the mutual fund estimates it would take approximately 27 days to sell off 50% of its portfolio. In other words, if the fund needs to raise cash quickly by selling off assets, it can liquidate half of its holdings within this time frame.
• 13 days to liquidate 25% of the portfolio: This part of the stress test result suggests that the mutual fund could liquidate 25% of its portfolio within approximately 13 days during the stress scenario. You can also conclude that a smaller portion of the portfolio could be sold off more quickly compared to the larger portion.

The result provides insights into the liquidity profile of the mutual fund's portfolio. It indicates the fund's ability to convert assets into cash within specific time frames under stress conditions. For investors, this information is crucial for understanding the fund's liquidity risk. A longer time frame required to sell off assets may indicate higher liquidity risk, especially if investors need to redeem their investments during turbulent market conditions.

Stress Results of Different AMCs

Here are the test results for different AMCs:

Here are a few important conclusions to draw from the results:

• Funds with a larger corpus have lower liquidity.
• Most mutual funds followed the above rule, but there were a few exceptions. For example, Tata Small Cap Fund said that it would take 35 days to liquidate 50% of its portfolio, which is significantly higher than peers with similar AUM.
• The worst liquidity is reported by SBI Small Cap Mutual Fund - 60 days to liquidate 50% of its portfolio. 

Before you go

The stress test results, along with the commentary from the different fund houses, should settle the nerves of investors. Hopefully, there won't be any panic selling in these funds now, as was expected a week earlier. Yes, the valuations are still a concern, but there is still space for growth potential. Now that the stress test results will be available at regular intervals, investors can get a better picture of the space.