Corporate level structural intervention by way of enhancing governance practices, regular audits and inspections by the regulatory bodies would send early signs of liquidity risk in mid and small-cap funds.

The capital market regulator SEBI had recently mandated routine stress tests to be conducted on small and mid-cap funds to highlight the potential liquidity risk associated with these funds when the markets come under pressure.

Besides stress test, ICRA Analytics said fund houses can create data bases leading to strengthening of financial disclosures to bring in transparency and throw up any possible liquidity risks associated with small and mid-cap funds.

While stress test may be a good approach to contain risk especially if the methodology is uniform, it said few interventions at the structural level could help prevent a situation of excessive valuation. Availability of a disclosure platform to capture near real time key data from companies would also help enable better monitoring through capturing of Early Warning Signals, said Ashwini Kumar, Senior Vice President and Head Market Data, ICRA Analytics.

Net inflows into small-cap funds increased by 30 per cent at ₹2922 crore in February. The open-ended mid-cap schemes witnessed 61 per cent growth in AUM as of February at ₹2.96 lakh crore while net inflows remained almost flat at ₹1,808 crore (₹1817 crore) in February.

Disclosure of risk-parameters and development of adequate stress tests is the need of the hour, educating investors about nuances of investments in schemes, said Kumar.

There is also a need to have investor-management discussion with greater frequency and shift to research-based investment from the growing trend of algo based investment/trading.

The stress testing should be in line with debt schemes for mutual funds with relevant parameters and optimum risk disclosures in Factsheet and Newsletter. High valuation without corresponding intrinsic and future value can result in a build-up of risk. Thus, realistic valuation is the key for optimum resource allocation and for macro stability.

Identification and Prevention of risk from irrational exuberance shall be the target of all probable measures which in turn helps boost confidence to these sectors and to impart stability to market. Hence necessary steps have to be initiated to intervene at right point to gauge rationality which in turn protects the interests of the investors, Kumar pointed out.

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