Editorial. MF stress test data has only limited value for retail investors

At the behest of Securities and Exchange Board of India (SEBI), starting March 15, small and mid-cap equity mutual funds have begun to disclose monthly data on liquidity stress tests of their portfolios. The first set of disclosures reveal that, in the event of sudden redemption pressures impacting 50 per cent of their assets, small-cap funds may take one to 60 days to liquidate their holdings. To sell 25 per cent, they estimate 0.22 to 30 days. Mid-cap funds have pegged the number of days for liquidating half their portfolios at 0.09 to 34 days and for 25 per cent at 0.05 to 12 days. As expected, the disclosures broadly show that funds with significant large-cap or cash holdings may take fewer days to cash out. But it is difficult to make much of the data beyond this.

From the investors’ point of view, funds that take fewer days to sell one half or a quarter of their portfolio aren’t necessarily a better bet, because the more important criterion in choosing funds is a long-term track record of benchmark-beating returns. In fact, the tests suggest that small-cap or mid-cap funds that adhere strictly to their mandate and stay off large-cap stocks, would take much longer time to cash out in the face of exceptional redemption demands. The tests also don’t reveal much about how portfolio returns can be hit by distress sales. Investors also need to evaluate the likelihood of the conditions for the stress tests playing out in real life.

Debt funds in India have faced bulk redemptions from institutions during turbulent times. But there have been hardly any instances of retail-focussed equity funds facing withdrawals of 25-50 per cent, even during exceptional times such as the Covid crash when markets plummeted 35 per cent. There is also the fact that the data can change very significantly if underlying assumptions are changed. For instance, the tests are modelled on the assumption that market volumes in times of stress will surge by three times the average volume in the last three months and that each fund will be able to participate to the extent of 10 per cent of traded quantity on any given day. These may or may not hold good during spells of market-wide turbulence. It would have helped if SEBI had shared the empirical data that prompted it to specify these assumptions for stress testing.

Overall, if SEBI’s objective in ordering these tests was to rid the small and mid-cap segments of froth, it has succeeded. But it seems unrealistic to expect retail investors to make sense of this disaggregated data. Stress testing would be more useful if SEBI were to conduct and interpret them on an aggregate basis. This would not only reveal risks to the fund industry at the system level, but would also enable SEBI to engage with individual fund houses to take precautionary measures.

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