There are pockets of froth in the small and mid-cap space in the equity markets that has the potential to become a bubble and burst affecting investors, said Madhabi Puri Buch, Chairperson, Securities and Exchange Board of India.

Also read: Instantaneous settlement vital to compete with assets like crypto, says SEBI chief

Talking to reporters on the mandatory stress testing disclosures to be made by mutual funds, Buch said that it would not be appropriate to allow the bubble to build because they are liable to burst and impact investors adversely.

Earlier this month the regulator had mandated that all asset management companies had to conduct stress tests on small- and mid-cap funds to assess the liquidity of a portfolio by calculating the time required to sell a quarter and half of its holdings, in the event of unusual redemption pressure. This would indicate how fast investors will be able to liquidate their holdings during a market collapse.

Disclosure format by March 15

A mandatory disclosure format will be ready by March 15 when AMCs will have to start disclosing key metrics for the small and mid-cap schemes.

“Every mutual fund will carry the disclosure about how the numbers stack up in small-cap and mid-cap funds, so investors are aware about the possible outcome of investing in small- and mid-caps in a stressed situation,” Buch said.

In addition, trustees also need to put in adequate risk management policies in place to avoid or mitigate risks arising from such bubbles and protect investors, she said. This is not something that the regulator has mandated but individual AMCs have been allowed to come up with their own risk management policies.

“We have suggested that the trustees should have a policy in place because it sounds like a prudent thing to do to protect the investors. So, they should look at it. They should formulate their own plans.”

Also read: More disclosures in the offing for SME IPOs to check manipulation, says SEBI chief

On the small- and mid-caps, Buch said the regulator had analysed the data and she said in some cases the “valuation parameters are off the charts and not supported by fundamentals and appearing to be case of irrational exuberance.”