Mutual funds stress test: What it means for you

• Investors should view stress test results as a metric indicating a fund's ability to withstand market volatility and unexpected challenges.
  
• Funds that require a lower number of days for liquidation are more liquid than funds that will take more number of days to liquidate are less liquid.
  
• Opting for funds that demonstrate robust liquidity profiles can provide investors with greater confidence in the fund's ability to weather storms and fulfil their investment objectives.
  

Over the past two years, several mid- and smallcap schemes have been launched by asset management companies to capitalise on the bull run in broader markets. Retail investors have also been drawn towards these funds as some stocks have doubled wealth in a few months’ time. What also drew retail investors towards mid and smallcaps is that sectors such as defence, capital goods, railways etc, were well represented here rather than large caps

According to Association of Mutual Funds in India (AMFI) data in 2023, smallcap funds saw net inflows of ₹41,035 crore and midcap funds saw net inflows of ₹22,913 crore. On the other hand, large cap funds witnessed net outflow of ₹2,968 crore.

“As money gushed into these schemes, the regulator’s concerns grew whether redemptions can be done easily in case a stress scenario occurs. Its worries intensified as it believed that pockets of markets looked overvalued and according to the SEBI chairperson there is ‘froth’ building up,” says Pankaj Shrestha, head of investment services, Prabhudas Lilladher, a financial services provider.

The stress test essentially means that if a certain class (small and mid cap mutual funds) is going through very high valuations, if suddenly the valuations come down, how the fund manager will be able to sell the portfolio and pay off the investors.

Suppose you have invested ₹10 lakh in a midcap scheme. Markets enter a correction phase and you want to redeem. Just like you, many other investors also want to do the same. “Considering that mid and smallcap stocks are relatively illiquid, will the fund house be able to sell quickly and honour all the requests? That is what SEBI wants to find out,” explains Shrestha.

The idea behind AMFI's Mutual Fund Stress Test, initiated by SEBI, is to instil resilience within mutual funds against various adverse scenarios. “By subjecting funds to simulated stress scenarios, regulators aim to ensure that funds can withstand market turbulence, sudden redemption pressures, interest rate fluctuations, and unforeseen economic downturns without compromising investor interests” says Soumya Sarkar, co-founder, Wealth Redefined, a mutual fund distributor.

The stress test number is the liquidity number. The two main numbers are in how many days it will take to liquidate 50% of the portfolio and how many days it will take to liquidate 25% of the portfolio.

“However, this calculation needs to be done after first removing 20% of the least liquid stocks,”says Shaily Gang, head of products, Tata Mutual Fund. A few other assumptions are also built in.


Source: AMC Websites, Top 5 mid and small cap funds according to AUM

What does it mean for the investor?

“SEBI is looking to ensure that during phases of market downturns and the resultant surge in outflows, the first set of investors shouldn’t be at an advantage to leaving those staying invested with low liquidity,” says Chirag Mehta, CIO, Quantum AMC.

The stress test provides an obvious indicator — funds that require a lower number of days for liquidation are more liquid than funds. Those that take more days to liquidate are less liquid.

“Opting for funds that demonstrate robust liquidity profiles and resilience in adverse scenarios can provide investors with greater confidence in the fund's ability to weather storms and fulfil their investment objectives, even in turbulent times,” says Sarkar.

However, stress test results alone should not influence investor decisions. Investors need to remember that funds which are purely invested in small cap stocks will take more days to liquidate their portfolio than funds which also have some exposure to large and mid cap funds. Also, funds that have a lower AUM will take a lower number of days for redemption compared to a fund with a large AUM.

“Investors should also look if the fund is compensating for the amount of risk taken. If the client is ok with a high risk high return profile, he should be ok with a portfolio which takes a slightly higher number of days,” says Gang.

Will the stress test results increase investor awareness and increase investor confidence? If an investor has his or her asset allocation in place, the stress test results should not be a matter of concern.