Stress Tests: The Mandate, The Results & Insights

Now that the Securities and Exchange Board of India (SEBI) has made it mandatory for fund houses to undertake stress tests for Mid-Cap and Small-Cap funds to see if redemptions can be made within a short period in the face of any financial crisis, it is important for investors to know more about how such stress tests are conducted and what they reveal [EasyDNNnews:PaidContentStart]

The broader market last month saw heightened volatility and investors witnessed a sharp drop in the net asset values (NAVs) of many broader market-based mutual funds. On an average, they have seen a drop of more than 2 per cent in one month, even after their recovery during the latter part. The ABSL Nifty Small-Cap 50 index fund saw its NAV dropping by 6.73 per cent in the last one month ending March 26, 2024. Here are the top five mid-cap and small-cap loser funds in one month:

One of the reasons for such a fall in the MF schemes can be attributed to the recent guidelines issued by the Securities Exchange Board of India (SEBI) regarding stress test compulsion for small-cap and mid-cap funds. The stress test results should be published on the fund house’s website, it was further mandated.

The Results
The stress test results for small-cap and mid-cap mutual funds in India have been disclosed, revealing how quickly these funds can liquidate a portion of their holdings under stress conditions. SEBI has mandated these tests to access the liquidity risk of mutual funds, particularly in scenarios where a significant percentage of investors request redemptions during market downturns. SEBI also asked the mutual funds to calculate the time required to liquidate 25 per cent and 50 per cent of portfolios, after removing the bottom 20 per cent of the portfolios based on script liquidity.

The objective of the test is to make investors aware of the risks and impact of market volatility on their equity portfolio and to help them take appropriate actions either to rebalance or redirect their mutual funds investments. For over three years now, mutual funds that invest in small-cap and mid-cap stocks have been the toast of Indian investors. With three-year annualised average returns on these funds for mid-cap at 23.48 per cent and for small-cap at 27.48 per cent, respectively, these funds have been an investor’s delight. They have been attracting a lion’s share of equity inflows. The huge inflows, in turn, prompted these funds to accumulate more small-cap and mid-cap stocks, thus keeping the party going.

From the table above, we can see that there is an increase of 19 per cent and 29.50 per cent in the AUM of mid-cap and small-cap funds at the end of FY22-23 compared to the AUM at the end of FY21-22. An enormous increase was seen in the AUM of mid-cap and small-cap-dedicated funds in FY23-24 compared to FY22-23 as the mid-cap AUM increased by 60 per cent and small-cap AUM increased by 87 per cent in FY23-24 till February 2024. The mid-cap and small-cap funds became the investors’ choice during these days. As such, the mid-cap and small-cap funds have given good returns for the past three years. The past three financial years’ mid-cap funds’ AUM grew more than that of small-cap funds. We can see that both the categories became the investors’ favourite.

What is a Stress Test?
A stress test which has been implemented by SEBI for small-cap and mid-cap funds is used to evaluate how a mutual fund might perform during extreme market conditions. It awakens investors to assess the funds’ ability to handle large redemption requests. A stress test will help regulators or investors to see whether an institution can function normally if the market conditions and sentiments become very negative. In bank regulation norms also, there is a procedure of carrying out a stress test for checking the liquidity and capital of the bank.

Every six months, the Reserve Bank of India conducts stress tests of banks to assess if they will fall short of capital or liquidity if they face stressful situations. A similar practice is also being implemented in mutual funds. The stress testing of small-cap and mid-cap funds is an attempt to determine how funds fare if they face large and sudden redemption demands. The stress test, whose methodology is not public, is designed to tell us in how many days would a fund be able to liquidate 25 per cent and 50 per cent of its portfolio.

The Need for a Stress
Test The liquidity for mid-cap and small-cap stocks can dry up too with immense redemption pressure. This wasn’t a very big issue as long as small-cap and mid-cap mutual funds managed relatively small assets. But with the flood of money in the past one year, mid-cap funds have grown to manage ₹2.95 lakh crore and small-cap funds were seen to be managing ₹2.49 lakh crore at the end of February 2024. The biggest AUM fund in mid-cap category manages ₹60,000 crore and in the small-cap category it manages ₹25,000 crore. At this size, selling even a 1 per cent position will mean putting through stock sales of ₹600 crore to ₹250 crore, which markets may struggle to absorb. If such sales were to happen in stocks with low liquidity, the impact costs could be high, resulting in disproportionate NAV declines.

What a Stress Test Reveals
At the end of each month, small-cap and mid-cap funds will calculate how long they will take to liquidate 50 per cent and 25 per cent of their portfolios based on their assumptions. The MFs will disclose this data in a standard format on their websites every month, starting from March 15, 2024. Similar disclosures will be done within 15 days of the end of every month in the future. Here are the stress test results of the top five funds by AUM in the mid-cap and small-cap categories.

The data shows that small-cap funds have a bigger challenge in dealing with stress scenarios than mid-cap funds. The biggest small-cap funds reported that they would take anywhere between 13 to 27 days to liquidate 25 to 50 per cent of their portfolio. Here, the only exemption is the Quant Small-Cap Fund. SEBI rules permit all mid-cap and small-cap funds to hold cash or other equities to the extent of 35 per cent of the assets. Small-cap funds and mid-cap funds that used this leeway to own Large-Cap stocks seemed to be better placed on liquidity. Mid-cap funds seem to carry much lower risk from bulky redemptions compared to the small-cap funds. Again, funds with significant large-cap holdings were better off.

If a fund says it will take 60 days to liquidate 50 per cent of its portfolio, does this mean it won’t honour redemptions? Stress testing is a hypothetical exercise which aims to capture what will happen to a fund in an extreme situation. Cases of mutual funds in India facing redemption demands of 25 per cent or 50 per cent of assets are very rare. When that has happened, it is Debt Funds that have faced such pressures rather than equity funds. Bond market liquidity in India is erratic and debt funds are held by corporate treasuries and institutions, which can trigger lumpy redemptions.

AMCs are aware of liquidity risks in small-caps and mid-caps and can use the 35 per cent leeway to hold large-cap stocks, apart from cash. SEBI regulations also allow funds to borrow to the extent of 20 per cent of assets to meet short-term liquidity needs. This gives funds a significant cushion. SEBI’s stress testing requirement is likely to force AMCs that have been flirting with risks to be cautious about illiquid names and own more liquid names. After all, no open-end fund would like stress test disclosures to alarm investors into redeeming their investments.

Key Takeaways
Here are some factors that investors should note from the results of the stress tests for mid-cap and small-cap fund:
1. Liquidity Concerns: The stress tests have highlighted potential liquidity risks in small-cap and mid-cap funds, which could impact the ability to meet redemption requests during market downturns.
2. Market Volatility Impact: Small-cap and mid-cap funds are more susceptible to market volatility, and stress tests underscore the importance of having robust risk management strategies in place.
3. Diverse Risk Profiles: There is a wide variation in risk profiles among small-cap and mid-cap funds. This indicates that investors need to carefully assess individual fund risk rather than relying on broad market trends. Spread investments across various asset classes to minimise risk.
4. Long-Term Perspective: Maintain focus on long-term investment goals and avoid making impulsive decisions based on short-term market movements.
5. Rupee Cost Averaging: Invest a fixed amount regularly, regardless of market conditions, to average out the cost of investments over time.
6. Investors Guidance: The stress test results serve as a guide for investors to understand risk-return trade-off and to make informed decisions based on their risk appetite and investment horizon.

The question is whether a stress scenario can be played out if an adverse global event were to suddenly unfold or the markets were to crash? Yes, it can. In fact, this stress testing is based on certain assumptions. A real-life situation can turn out worse than what is being assumed. It is also very difficult to guess during difficult times how liquidity and investor behaviour will face a crisis of this nature.

Is it the Time to Sell?
Investors have long been aware that small-cap and mid-cap funds carry inherent risks, often holding stocks with limited liquidity. Stress testing serves to quantify the potential impact of these risks but should not be viewed as a trigger to sell your funds. Selling funds that are part of your long-term investment strategy is generally ill-advised. While exiting funds may seem straightforward, timing a re-entry into the same funds during market downturns can be challenging. Some small-cap and mid-cap funds have even suspended accepting lump sum investments as a proactive measure.

For example, Nippon Small-Cap Fund ceased accepting lump sum investments in July 2023, while ICICI Prudential Mutual Fund followed suit for its mid-cap and small-cap funds from March 14, 2024. This action is taken to address risks associated with volatility and valuation concerns in these market segments. Restrictions on lump sum investments are typically temporary and aimed at safeguarding existing investors during periods of market uncertainty. The duration of such measures varies among funds and is contingent upon market conditions. Investors should stay informed through official communications from fund managers and monitor updates on fund house websites. For specific inquiries, direct communication with the mutual fund house is recommended.

Conclusion
If a stress test says that a fund can sell off half of its portfolio in seven days, it does not mean such a thing will happen. This means that if you make an Excel spreadsheet with certain assumptions, the number seven comes up as the answer. That’s it. A stress test is not a tool for predicting what will happen. Stress tests are carried out based on certain assumptions and this cannot be the only point to sell investments in mid-cap and small-cap funds. Investors should use stress test results as one of several tools to assess the risk profile of their investments.

Remember, these tests are part of a broader risk management strategy and should be interpreted within the context of the overall market and individual investment goals. These tests are now going to happen regularly for mid-cap and small-cap funds on a monthly basis. As this stress test is new for Indian mutual fund investors, they are advised not to lose their focus from long-term mutual fund investment goals. Maintain long-term investment horizons of at least five years for mid-cap and small-cap funds. Avoid allocating emergency money to these funds. Allocate 10-20 per cent in small-cap and 20-30 per cent in mid-cap funds.

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