First, let us begin by clarifying what a mutual fund is.
A mutual fund is an investment vehicle that collects money from multiple investors to invest in various financial assets including equities, government and corporate bonds, and money market instruments.
The mutual funds are managed by managers, who invest in stocks, bonds and other assets according to the fund’s investment objectives.
The gains generated from these investments are distributed proportionately among the investors after deducting applicable expenses and fees based on the net asset value.
In exchange for managing the capital, mutual funds usually charge investors a small fee of a fixed percentage of the total investment.
Size of Indian mutual funds industry
The Indian mutual fund industry’s assets under management has grown significantly, rising from Rs10.51tn (£95bn) on December 31 2014, to Rs66.93tn (£606bn) on December 31 2024 – an increase of more than six times over 10 years.
The popularity and growth of mutual funds as an investment tool are driven by a shift towards financial savings, leading to increased participation from retail investors and a broader acceptance of mutual funds as an investment tool.
Key contributors to this expansion include systematic investment plans (SIPs), which reflect steady retail investment interest, as well as awareness campaigns such as the Association of Mutual Funds in India’s “Mutual Funds Sahi Hai” initiative, which have helped demystify mutual fund investments for the average retail investors.
Regulatory implications
Significant regulatory reforms from the Securities and Exchange Board of India (SEBI) such as registration requirements, fee caps and independent oversight help ensure transparency, investor protection, and robust risk management and have helped enhance confidence in the mutual funds industry.
However, despite the rapid growth over the past decade, concerns persist regarding high concentration risks in specific areas or securities, liquidity challenges, and the ability of mutual fund houses to manage large-scale redemption requests during volatile markets.
SEBI’s recent directive on stress-test disclosures aims to address these challenges and ensure the growth and sustainability of the mutual funds industry in India as it continues to expand and is now a vital component of India’s financial system.
In 2024, SEBI mandated that all types of mutual funds conduct stress tests.
To comply and ensure transparency, mutual funds must disclose the results of these stress tests every 15 days through their website and on the AMFI website.
A stress test simulates various market conditions and scenarios to assess how a fund would perform under different circumstances.
This process helps investors understand how a specific mutual fund scheme might react during high volatility, sudden interest rate shifts, and low liquidity periods, especially during extreme capital redemptions.
Ultimately, it compels mutual funds to account for tail risk and better protect investors’ capital from unexpected losses.
Requiring mutual funds to disclose their stress-testing results regularly, SEBI provides investors with essential information about potential issues in the strategies of their chosen mutual fund schemes.
This transparency enables investors to make more informed decisions.
The increasing participation of retail investors presents unique challenges, especially since many first-time investors may lack the financial literacy needed to understand the complexities of mutual funds and anticipate the effects of market fluctuations.
SEBI’s directive helps bridge this knowledge gap by offering more precise information regarding risk exposure, aligning with its primary goal of protecting investor interests.
This initiative assists investors in identifying risky fund schemes early through stress-test warnings and boosts their confidence, as they can see that the funds have passed stress tests.
SEBI focuses extra on small and mid-cap funds, which carry a higher risk during market uncertainty/volatility.
Furthermore, SEBI’s initiative addresses broader systemic concerns, as unmanaged risks, such as liquidity issues, can have cascading effects on the more prominent Indian financial market and the banking sector.
Industry comparison
These transformative changes, however, are lagging behind some of the larger financial markets.
In the US, the Securities and Exchange Commission mandated requirements for daily and weekly liquidity levels, shorter portfolio maturities, and stress testing following the 2008-09 financial crisis in 2010.
Additionally, starting in 2016, funds must disclose their target for daily and weekly liquid assets as a percentage of total fund assets on their websites each day, along with the net shareholder flows from the previous day.
Similarly, in the UK, mutual funds are required to conduct stress tests and disclose the results to investors, by specific guidelines set by the Financial Conduct Authority based on updates from 2016.
From 2023, UK funds are also subject to climate-related disclosure requirements.
The stress tests focus on various market scenarios, including the impact on NAV and liquidity. The FCA also mandates that they report the results of the stress to them.
Conclusion
SEBI’s mandate to disclose stress tests to investors enhances accountability through regular stress testing as it helps investors know whether the fund is always ready to manage inherited risks.
This transparency is essential for ensuring the sustainability and growth of the mutual fund sector while strengthening investor confidence, particularly among retail investors who may not have adequate resources to conduct their analysis.
It helps maintain market integrity in India’s rapidly evolving financial and economic landscape. This requirement is timely and necessary, as it aligns India’s stress-testing standards with those of other countries, especially the US and UK, which have had these requirements in place for a long time.
Akhil Khunger is a financial engineer – quantitative analytics at Barclays