Why the ongoing MF stress tests should not worry you

Alarm bells rang out recently, when the Securities and Exchange Board of India (Sebi) chairperson, Madhabi Puri Buch, spoke of the froth building up in the small and mid-cap stock, the past few months. Valuations of mid cap & small cap companies had run ahead of the fundamentals and were stretched to unreasonable levels and  she warned that this bubble should not be allowed to blow bigger. The actions of both the Reserve Bank of India and Sebi, against major players such as Paytm, IIFL Finance, and JM Financial Products also drew attention to the irrational exuberance among investors.

Heeding these indicators a few asset management companies (AMCs) had already started capping investment inflows into the relevant funds. But pursuant to the Sebi directive, the Association of Mutual Funds in India (AMFI) instructed all AMCs to stress tests on their small and mid-cap funds and publish the results to give investors insight into their risk profile and transparency.

The tests covered metrics like liquidity, portfolio turnover, standard deviation & Price to Earnings ratio. The portfolio liquidity would reveal the time required to liquidate 25 per cent & 50 per cent of the portfolio during sharp market downturns triggered by black swan events. In effect, the stress test would reveal the ability of a fund house to handle mass redemptions that happen during any turmoil and manage liquidity.

Stress tests’ takeaways

The stress test was conducted across 56 small-cap and mid-cap schemes. The key takeaways from the stress tests released by the AMCs revealed that small cap funds took anywhere between 22 days to 60 days to liquidate 50 per cent of their holdings & 11 to 30 days to liquidate 25 per cent of their portfolio. Data released for mid cap funds showed that they did better. Mid cap funds took between 7 days to 34 days to liquidate half of their holdings and between 6 days to 17 days to liquidate a quarter of their portfolio. 

Looking at the data one may wonder why it should take so much time for the fund to   liquidate stocks when the normal redemption time in any fund for an investor is T + 2 days. Anything beyond that reflects the stress levels in the portfolio.

How does this impact your investment?

Before taking any hasty decision ask yourself how many funds have faced a situation where total redemptions were equal to 50 per cent of their assets under management? None, in fact, in the history of mutual funds in India. This is similar to a scenario in the banking system when there is a run on the bank and 50 per cent of the deposits are withdrawn by depositors of a commercial bank in a space of a few days.

Also do remember that small cap and midcap funds have the mandate to hold up to 35 per cent in large cap stocks. Funds that had a higher exposure to large cap stocks have done better in the stress tests. Also, most of the small and mid cap funds are sitting on cash levels of around 10 per cent and can handle redemptions better. In case of extreme liquidity crunch, as per Regulation 44 of SEBI (Mutual Fund) Regulations of 1996 an AMC can borrow up to 20 per cent of the net assets of the scheme for a maximum period of 6 months to meet redemption pressures.

So to those who have invested in these funds to meet long term financial goals, there is no need to panic. Focus on your investment, trust your fund manager & don’t be distracted by noises around you.