SEBI-Mandated Stress Tests

Table of Contents

Context: For the past three years, small and mid-cap stock mutual funds have been extremely popular among Indian investors.
These funds have delivered impressive returns of 24% and 22% respectively over the three-year period, attracting a significant portion of equity investments.
This surge in investments has encouraged these funds to acquire more small and mid-cap stocks, sustaining their strong performance.
This small and mid-cap boom caught the SEBI’s (Securities and Exchange Board of India) attention when it called it a ‘froth or bubble’ and it told mutual funds to put a framework in place to protect retail investors in case of a market crash.
- A bubble is an economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets.
- This fast inflation is followed by a quick decrease in value, or a contraction, that is sometimes referred to as a “crash” or a “bubble burst.”
It prompted the Association of Mutual Funds in India (AMFI) to tell mutual funds to conduct ‘stress tests’ and publish the result on their websites.

Analysis

What are Large Cap, Mid Cap and Small Cap Stocks?

Market Capitalisation can be defined as the total value of the company that is traded on the stock market. It is calculated by multiplying the total number of shares by the current market per share price.
As per the SEBI guidelines the companies are classified as:
- Large Cap: Companies ranked between 1 and 100, when sorted by market capitalisation.
- Mid Cap: Companies ranked between 101 and 250, when sorted by market capitalisation.
- Small Cap: Companies ranked beyond 250, when sorted by market capitalisation.
Large cap funds offer stability and lower risk, while mid cap funds provide growth opportunities with moderate risk, and small cap funds offer potentially high returns but with increased risk.

What is a Stress Test?

Stress testing of small and mid-cap funds is an attempt to determine how these mutual funds fare if they face large and sudden redemption (withdrawal of money) demands.
The test checks two things: selling speed and price impact.
- Selling speed checks how quickly can a fund manager sell small company stocks if many investors redeem their investments. and
- The price impact checks whether selling these stocks would bring down their price significantly or not.

SEBI Mandated Stress Test | News Makers: UPSC 2024-25

Why do we need Stress Tests?

The stress test was done to clear the market regulator’s concern about froth in the small and mid-cap segments on the back of relentless inflow in these schemes, backed largely by retail investors chasing high returns.
A few years ago, small- and mid-cap mutual funds managed relatively small assets.
But with the flood of money in recent years, small-cap funds have grown to manage ₹2.49 lakh crore and mid-cap funds ₹2.95 lakh crore by end of February 2024.
The leading funds in these sectors currently range from ₹25,000 crore to ₹60,000 crore. With such large holdings, even a minor 1 percent sell-off would require transactions worth ₹250 crore to ₹600 crore.
This magnitude of selling could overwhelm the market’s capacity to absorb it. If these sales occur in stocks with limited trading volume, it could lead to significant increases in transaction costs, causing NAV to drop more than expected.
- NAV stands for Net Asset Value. The performance of a mutual fund scheme is denoted by its NAV. It is the market value of the securities held by the scheme.

GS Foundation One Year

How are Stress Tests conducted?

At the end of each month, small- and mid-cap funds will calculate how long it will take to liquidate 50 per cent and 25 per cent of their portfolios based on four assumptions.
- First, they will arrive at the average trading volumes for all their stock holdings for the past three months.
- Two, they will exclude the bottom 20 per cent illiquid stocks.
- Three, they will assume a three-fold spike in volumes on a hypothetical trading day when markets are under stress (higher market volatility usually spikes volumes).
- Four, they will calculate how many days it may take to sell their holdings, if able to participate to the extent of 10 per cent of a stock’s traded quantity on the given day. This yields the number of days a fund will take to liquidate 25 per cent or 50 per cent of its portfolio.

How should investors interpret the data?

The main data points investors need to look out for are the number of days estimated for liquidating 50 per cent and 25 per cent of the portfolio.
They also need to check if the fund has a concentration problem — a few investors holding a large proportion of assets.
Funds that take longer to liquidate their holdings will have a greater challenge in meeting exceptional redemption demands.
- They could also face higher impact costs when selling.
Concentrated investors make a fund more susceptible to bulky redemptions.

What does the first set of data show?

The data shows that small-cap funds have a bigger challenge in dealing with stress scenarios, than mid-cap funds.
Small-cap funds with assets of ₹10,000 crore or more, generally reported a longer time to liquidate.
Mid-cap funds seem to carry much lower risk from bulky redemptions compared to small-cap funds.
Most mid-cap funds estimated taking about half the time to liquidate 50 per cent of their portfolios as small-cap funds from the same AMC (Asset management Company).
Investor concentration was slightly higher for mid-cap funds.

Should investors sell their small-cap and mid-cap funds now?

That small and mid-cap funds are risky and hold stocks with patchy liquidity has been known for some time. Stress testing only quantifies the impact of these risks. Therefore, stress testing cannot be a trigger to sell your funds.
But if you were not aware of the risks lurking in these funds when you invested and cannot handle sharp draw-downs, you should reduce your exposure to them.
You can decide to book profits on any of your small or mid-cap holdings if you have uncomfortably high allocations to them within your equity portfolio or need the money within the next 3-4 years. Selling funds that are a part of your long-term portfolio isn’t a good idea.

What are the regulatory provisions to help the retail investors?

Bond (or debt) market liquidity in India is erratic and debt funds are patronised by corporate treasuries and institutions, which can trigger bulky redemptions.
- Equity funds are held mainly by retail investors. History suggests that, when markets fall, retail investors may stop new investments, but they don’t immediately redeem from equity funds.
Two, AMCs are aware of liquidity risks in small and mid-caps and can use the 35 per cent leeway to hold large-cap stocks, apart from cash.
- SEBI regulations also allow funds to borrow to the extent of 20 per cent of assets to meet short-term liquidity needs. This gives funds a significant cushion.
Three, SEBI’s stress testing requirement is likely to force AMCs that have been flirting with risks to lighten up on illiquid names and own more liquid names.
- After all, no open-end fund would like stress test disclosures to alarm investors into redeeming.

Evaluate Yourself

Q. With reference to the stock market, consider the following statements:

Mutual Funds that take longer to liquidate their holdings face a greater challenge in meeting exceptional redemption demands.
Small and mid-cap funds face higher impact costs when selling in comparison to the large cap funds.

Which of the statements given above is/are correct?

(a) 1 only

(b) 2 only

(d) Neither 1 nor 2

Answer: c

Explanation:

Market Capitalisation can be defined as the total value of the company that is traded on the stock market. It is calculated by multiplying the total number of shares by the current market per share price.
As per the SEBI guidelines the companies are classified as:
Large Cap: Companies ranked between 1 and 100, when sorted by market capitalisation.
Mid Cap: Companies ranked between 101 and 250, when sorted by market capitalisation.
Small Cap: Companies ranked beyond 250, when sorted by market capitalisation.
Large cap funds offer stability and lower risk, while mid cap funds provide growth opportunities with moderate risk, and small cap funds offer potentially high returns but with increased risk.
Small and mid-cap mutual funds take longer to liquidate their holdings and thus face a greater challenge in meeting exceptional redemption demands. So, statement 1 is correct.
Small and mid-cap funds also face higher impact costs when selling in comparison to the large cap funds. So, statement 2 is correct.

Therefore, option (c) is the correct answer.

Relevance: The Association of Mutual Funds in India (AMFI) told mutual funds to conduct ‘stress tests’ and publish the result on their websites.

Subject: Current Affairs | Economy: Capital Market

Tags: Factual | Easy Difficulty

References:

Q. How can SEBI’s mandate for stress tests in India’s small and mid-cap mutual funds address market stability concerns, overcome implementation challenges, and ensure effective investor protection through transparent and regulatory-compliant practices? (Answer in 250 words)

Introduction

In response to the surge in popularity of small and mid-cap stock mutual funds among Indian investors, the Securities and Exchange Board of India (SEBI) has mandated stress tests.
This initiative aims to address concerns about market stability and investor protection in the event of a market crash or significant downturn.

Justifications for SEBI-Mandated Stress Tests

The significant inflow of investments into small and mid-cap funds has raised concerns about market froth or bubble, prompting regulatory intervention.
SEBI’s stress tests serve to evaluate the resilience of these funds to sudden redemption demands and market stress scenarios.
With small-cap funds managing assets worth ₹2.49 lakh crore and mid-cap funds ₹2.95 lakh crore, the potential impact of mass sell-offs on market liquidity is substantial.
Stress testing is essential to ensure the stability and integrity of the financial market, protecting retail investors from undue risks associated with these funds.

Challenges in Implementing Stress Tests

While stress tests are crucial, their implementation poses several challenges. Fund managers must accurately assess selling speed and price impact, considering the liquidity and trading volume of small and mid-cap stocks.
Additionally, interpreting stress test results requires investors to understand the implications of fund concentration and potential impact costs.
Moreover, stress testing may not serve as a trigger for immediate fund divestment but rather as a tool for informed decision-making regarding portfolio allocation.

Recommendations for Implementation

Enhanced Transparency: Mutual funds should regularly conduct stress tests and publish the results on their websites to enhance transparency and investor awareness.
Investor Education: SEBI and mutual fund associations should provide educational resources to help investors interpret stress test data and understand the risks associated with small and mid-cap investments.
Regulatory Provisions: SEBI regulations should be enforced to ensure compliance with stress testing requirements, encouraging fund managers to mitigate liquidity risks by diversifying portfolios and holding more liquid assets.
Risk Mitigation Strategies: Fund managers should develop contingency plans to address potential liquidity challenges, including holding large-cap stocks and maintaining cash reserves to meet redemption demands.
Long-Term Perspective: Investors should adopt a long-term perspective when evaluating small and mid-cap funds, considering their risk tolerance and investment objectives before making decisions based on stress test results.

Conclusion

SEBI-mandated stress tests play a crucial role in safeguarding the interests of retail investors and maintaining market stability amidst the growing popularity of small and mid-cap funds in India.
By implementing robust stress testing mechanisms and fostering investor education, regulatory authorities and fund managers can effectively manage the challenges associated with these investments, ensuring a resilient and transparent financial ecosystem.

Practice Question:

Q. Stress testing in mutual fund industry in India may not serve as a trigger for immediate fund divestment but rather as a tool for informed decision-making regarding portfolio allocation. Comment. (Answer in 250 words)