“The stress test results provide insights into the liquidity profile of mutual fund portfolios, indicating the fund’s ability to convert assets into cash within specific time frames under stress conditions,” says Kshitiz Mahajan, CEO of Complete Circle Wealth.
In an interview with ETMarkets, Mahajan said: “The results also reveal the stock price impact of large redemptions, allowing investors to make more informed decisions,” Edited excerpts:
Q) What is stress test panic, which is spooking the market?
A) A stress test determines the time within which investors can recover their investment in the event of a downturn in the equity market and a subsequent surge in investor redemptions.Asset management companies (AMCs) conduct these stress tests fortnightly to assess the liquidity of small and midcap portfolios.
During the test, they assess how quickly a fund manager can sell small and mid-company stocks if many investors request redemptions.
It also tests the potential price impact of selling these stocks, determining whether their prices would significantly decrease.
Recent results indicate that for the redemption of around 25% of the portfolio, most schemes are taking over 2-3 days (TAT for redemption in equity scheme is T+2 days).
Q) Sebi has tried to take a cautious approach in case of an unfavorable event in the markets — does that mean that Sebi is expecting something like this to happen?
A) Valuations are stretched in the mid and smallcap space, with a significant increase in these categories’ performance in the 2017 calendar year followed by a correction in 2018.Sebi is concerned about protecting against similar events in the future, as investors are heavily investing in these categories.
In January alone, there was a significant increase in the number of folios added to small and midcap categories, indicating investor interest.
Q) Has the industry gained something out of this exercise?
A) The stress test results provide insights into the liquidity profile of mutual fund portfolios, indicating 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. The results also reveal the stock price impact of large redemptions, allowing investors to make more informed decisions.
Q) What does the exercise mean for investors or MF holders?
A) Stress tests provide investors with insights into how mutual fund investments might perform under adverse market conditions.
Understanding potential risks and vulnerabilities in the fund’s portfolio helps investors make more informed decisions and manage expectations regarding potential losses during market downturns.
Q) Should investors now select funds based on the stress test results?
A) Yes. Investors can make informed decisions by considering the liquidity profile of funds revealed in stress test results. This data, available every 15 days, helps clients plan their allocation.
Q) Do AMCs have the flexibility to change the strategy to manage funds based on the stress test?
A) AMCs must maintain a minimum of 65% in smallcap or midcap as per category. They can adjust remaining allocations, cap flows, or stop lump sum flows if liquidation days are high. They can also cap SIP inflows.
Q) There is already caution on small & midcaps and now will future flows be impacted post the stress test?
A) Investors looking to allocate funds in small and midcap should align their long-term goals with these categories of funds. It’s crucial to diversify across various asset classes and not allocate based solely on past returns. Industry flows in small and midcap stocks may also come through other categories.
Q) How will this improve future investing? Will this parameter be mentioned in the NFO as well or at the time of rolling out new funds?
A) Stress tests bring transparency, compliance, and hygiene to investing, educating investors about the funds they are entering. It benefits AMCs, investors, and stakeholders.
While it may not be mentioned in NFOs as tests can only be conducted after the portfolio is carved out, it will become an essential aspect of fund evaluation.
Q) How is the stretched test designed?
A) Sebi and mutual funds collaborated on the stress test’s methodology. The test involves pro-rata liquidation of 25% or 50% of the portfolio, excluding the bottom 20% based on illiquidity.
It considers a 10% participation volume of three-month daily average traded volumes on both NSE and BSE with three-fold volumes, assuming a 10% participation due to increased trading volumes during market stress.
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)
