Mutual Fund Asset Management Companies (AMCs) have publicly shared the results of SEBI-mandated stress tests for their mid and small cap schemes. While the stress test has revealed some interesting insights about all small-cap and mid-cap mutual funds, this exercise seems to have generated a lot of confusion among investors. (Read about mutual fund stress test results for small cap funds in April 2024 here)

In this article, The 1% News explains the stress test and its implications so that you can keep the stress aside and march forward in your investment journey.

What is stress test in mutual fund?

Stress test is an assessment of liquidity of a small or mid cap mutual fund. This test shows how quickly the fund manager of a scheme can sale its stocks if a large number of investors apply for redemption.

Stress test result also gives an idea about the time within which an investor may be able to recover his/her investment in the event of a surge in redemption requests.

Funds were asked to estimate how long will they take to exit 25% and 50% of their portfolio in case there is a sudden surge in redemptions. However, AMCs were allowed to exclude 20% of the most illiquid stocks for stress tests.

What is the impact of mutual fund stress test on investors?

Till now, you might have read several commentaries saying there is nothing to worry about the mutual fund stress test. Such commentaries are, however, only partially correct.

Sure, you don’t need to worry too much the about the stress test numbers. But you do need to know how it might impact your financial planning or wealth generation journey. Moreover, it is important for every investor to understand the impact of any regulatory change.

Stress test is currently the hottest regulatory development for mutual fund investors. Therefore, if you are invested, it is a good time to know why this test is important.

Importance of Stress Test

Stress test provides an insight about how mutual fund investments might perform during market downturn. By knowing the stress test result, investors can understand potential risks and vulnerabilities to their portfolio. This will further help in making well-informed decisions.

Stress test result also helps in understanding a fund’s liquidity risk during stress scenario. For example, SBI Small Cap Fund has revealed it would need 60 days to sell off 50% of its portfolio and 30 days to liquidate 25% of its portfolio. What does it mean?

• 60 days to sell off 50% of portfolio: This shows that in a stress scenario, SBI Mutual Fund estimates it would take approximately 60 days to sell off 50% of its small cap fund’s portfolio. Or, if SBI Small Cap sees massive redemption requests during market downturn, the fund house would be able to raise cash quickly by liquidating or selling half of the holdings of its small cap fund within the 60-day time frame.
• 30 days to liquidate 25% of the portfolio: This shows that SBI Mutual Fund might be able to liquidate 25% of its small cap fund’s portfolio within approximately 30 days in stress scenario. It also shows that the AMC can sell a smaller portion of its portfolio more quickly compared to the larger portion.

Longer time to sell off assets might indicate higher liquidity risk to an investor who might need redemption during adverse market conditions. That said, investors don’t need to worry too much about the stress tests for two reasons:

First, equity mutual funds haven’t seen any big liquidity crisis till now. The last time it happened was in debt segment when Franklin Templeton faced heavy redemption in six schemes in 2020. The AMC responded by closing six debt schemes but the issue ran into litigation. Eventually, the liquidation process was handed over to SBI Mutual Fund. In a few years, investors were able to recover most of their money.

Second, if you have done your asset allocation correctly, preferably after consulting a SEBI-registered investment advisor, stress test might not impact your investment journey. In case of doubt, you can always go back to your investment advisor for clarity on the possible impact of stress test on your portfolio’s liquidity.

Full List of Small Cap Mutual Funds and their Stress Test Results

Full List of Mid Cap Mutual Funds and their Stress Test Results

• The numbers above show that most mutual funds with larger corpus have lower liquidity. One exception is Tata Small Cap Fund, which says it might take 35 days to liquidate 50% of its portfolio despite have lower AUM. Funds with AUMs similar to Tata Small Cap have reported higher liquidity.
• SBI Small Cap fund reported worst liquidity

What is behind the Stress Test?

It is also important to understand the context behind stress tests. The market regulator often intervenes when it senses something off, that may affect investors’ interests.

SEBI has earlier warned of “froth” in small and mid cap segments, apparently due to massive inflows and inflated valuations. And SEBI’s concerns are not unfounded. Between January 2022 to February 2024, AUM of small cap funds more than doubled from Rs 1.06 trillion to Rs 2.49 trillion. In the same period, AUM of mid cap schemes jumped from Rs 1.58 trillion to 2.95 trillion.

Further, the massive inflow of money into small and mid cap schemes on the back of impressive returns has led to liquidity fears. There is also less liquidity in small and mid cap space.

In such a situation, the regulator wants to ensure the AMCs have sufficient liquidity and proper plan in place to sell stocks to meet any unexpected surge in redemptions. Following SEBI’s direction, the Association of Mutual Funds in India (AMFI), asked AMCs to conduct stress tests of their small and mid cap schemes and publicly share the data every 15 days, starting from March 15, 2024.

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Disclaimer: The above content is for informational purposes only. Please consult a SEBI-registered investment advisor before investing in mutual funds.