Capital market regulator Securities and Exchange Board of India (Sebi) is planning to implement an industry-wide stress test for small-cap funds, moving away from the previous trend of conducting fund-specific assessments. Sebi’s whole-time member Ananth Narayan mentioned this significant development during his address at the Cafe Mutual Conference.
He added the capital markets regulator will soon publish the results of an industry-wide stress test conducted on equity mutual funds (MFs).
Narayan highlighted the impressive expansion observed in the mid- and small-cap sectors, pointing at that more than 40% of mid- and small-cap stocks have experienced a more than five-fold increase in value over the past five years.
Despite Sebi’s policy of not making direct comments on market valuations, Narayan underscored the importance for stakeholders to contemplate the rapid surge in prices. He reiterated that Sebi’s primary function is not to predict or manipulate market movements but to ensure the stability and resilience of the financial ecosystem.
Narayan said that despite a substantial increase in mutual fund holdings of stocks, the number of days needed to cater to a hypothetical 10-20 per cent sudden redemption had not significantly changed between March 2020 and March 2024.
Fund houses have responded to concerns about “frothy valuations” by initiating the publication of stress test results for smallcap schemes every fortnight since March. This move was prompted by Sebi’s directive in light of substantial inflows into smallcap and midcap funds despite worries over high valuations. The objective of these stress tests is to enhance investor awareness and ensure transparency in the market.
Narayan raised doubts about the secondary market’s capacity to withstand MF sales during stressful periods, considering their eagerness to purchase assets during favorable conditions. He highlighted a noteworthy increase in holdings of midcap and smallcap companies by MFs, domestic institutional investors, and individuals, reaching 60.6% of the free float compared to 54.3% between March 2020 and March 2024.
Small-cap funds
The BSE Small-cap index performance has been remarkable, showcasing gains of 27.9% in the current calendar year, surpassing the 11.3% increase in BSE Sensex. Notably, the small-cap index marked a significant growth of 47.5% in 2023.
Despite a momentary setback in March 2024 triggered by SEBI’s apprehensions regarding valuations in the sector and the subsequent stress test mandate for mutual fund houses, the upward trajectory of small-cap stocks remains relentless.
The relentless rally in small-cap stocks can be attributed to India’s sturdy economic fundamentals, solid corporate balance sheets, and the substantial inflow of new retail investors, particularly through the SIP route of mutual funds, over the recent years.
Within the thriving small-cap segment, the Small Cap Fund stands out as the best-performing category among diversified equity mutual funds.
In July, the mutual fund industry’s net assets under management (AUM) reached an impressive RS 64,96,653.14 crore, according to AMFI data. However, mid-cap and small-cap funds faced a slowdown in new investments. Small-cap funds still attracted net inflows of Rs 2,109.20 crore, while mid-cap funds garnered Rs 1,644.22 crore in fresh investments for the month.
What is a stress test?
The stress test calculates the number of days required to liquidate assets based on recent trading volumes. Stress tests are a common practice where an entity is exposed to a variety of hypothetical scenarios mimicking extreme market conditions. These scenarios include significant drops in asset prices, sudden shifts in interest rates, or economic recessions. Through thorough analysis of the entity’s reactions to these stressors, analysts and investors can evaluate its capacity to endure adverse circumstances and pinpoint any vulnerabilities and potential risks.
In the context of mutual funds, stress tests play a crucial role in helping investors comprehend how the fund’s assets and investment approach may fare in times of market turbulence or instability. This insight is invaluable for investors aiming to evaluate the risk exposure of a mutual fund and make prudent decisions regarding their investment strategies.
Sebi designed the mutual fund stress test to evaluate the resilience of liquidity management in situations where 25% or 50% of investors request withdrawals, particularly in times of extreme market volatility. The Association of Mutual Funds in India (AMFI) mandated its members to disclose the outcomes of stress tests every 15 days. These stress tests aim to assess the expediency with which fund managers can liquidate portfolios in response to redemption demands amidst adverse market circumstances.
The test, designed by the Association of Mutual Funds in India (Amfi), included conditions like pro-rata liquidation after removing the 20 per cent least liquid holdings.