In early 2024, the Securities and Exchange Board of India (SEBI) mandated that all mutual fund houses disclose the results of stress tests for their small-cap and mid-cap schemes. Following this directive, the Association of Mutual Funds in India (AMFI) required fund houses to publish these stress test results by the 15th of each month based on the preceding month’s data. The first disclosures were made on March 15, 2024.
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Stress test criteria – “Pro-rata liquidation of 25% / 50% of the portfolio, after removing the bottom 20% of the portfolio based on scrip liquidity, considering 10% participation volume of three-month daily average traded volumes on both NSE and BSE with three-fold volumes.”
Several improvements and guidelines for conducting stress testing are required in the process. The author has outlined its suggestions along with the rationale for the same below.
1 Pro-rata liquidation of 25% / 50% of the portfolio
Philosophy: These are scenarios for which mutual funds’ liquidity is being tested. In scenarios where 25% or 50% of investors came in for redemptions, how long will it take for a fund manager to liquidate his holdings and, therefore, the number of days to honour these redemptions?
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Author’s Views: Portfolio liquidity should be measured by the time it will take to liquidate the entire portfolio i.e. 25%/ 50% / 75% /100%.
25% and 50% Redemption scenarios are not the worst-case scenarios
On the worst day of a liquidity crisis 100% liquid portfolio would mean correct “transactable NAV” for incoming and “redeemable NAV” for outgoing investors
Required Improvements: Pro-rata liquidation of 25% / 50% / 75% / 100% of the portfolio
2 Removing the bottom 20% of the portfolio based on scrip liquidity
Philosophy: This is to allow room for a fund manager to hold on to illiquid stocks that he/she may think are high quality or would want to hold on to for a longer period for better returns. Normally, when redemption requests are placed, a fund manager won’t be cutting his most illiquid stocks first; those will be wound up last. Since the stress test is for scenarios of 25% or 50% redemptions, the most illiquid part of the portfolio need not be touched.
Author’s views: The philosophical argument against this is that old saying in English “A chain is as strong as its weakest link”. Therefore, a mutual fund portfolio is as liquid as its most illiquid securities.
Removing the bottom 20% of the portfolio based on script liquidity gives a distorted version of the illiquidity of the portfolio.
There is a chance where in a mutual fund portfolio may have many illiquid securities as the top 50% of the portfolio.
Required Improvements:Removing the bottom 20% of the portfolio based on scrip liquidity is not the correct way to stress test an MF.
3 Three-month average trade volume
Philosophy: This is just a reasonable period that reflects the prevailing market conditions and investor interest in individual stocks.
Author’s views: Three months is too short for a trend to be used for interpolation or extrapolation.
Required Improvements: Stress testing must be done for 1-year average trade volume
4.Three-month daily average traded volumes on NSE and BSE with three-fold volumes.
Philosophy: Typically, when markets turn volatile, trading volumes spike. So, when markets go down, even if the stock price goes down, more shares get traded as people scramble to buy and sell. Past data shows that trading volumes are around three times the average prevailing volumes under stress.
Author’s views: On the worst days, Financial markets freeze and liquidity vanishes. The trend that has been used to provide the argument that trading volume 3 times is based only on post-COVID trends.
Required Improvements: For correct stress testing, we should take 1-year Average trading volume on both NSE and BSE with ½ the volume for calculation
5. A 10% participation
Philosophy: This is under the assumption that a fund will only be able to sell down 10% of the traded volume through market sales in a day because everyone is scrambling to sell. This is just an assumption.
Author’s views: This is a sensible assumption to be used for stress testing.
Summary: This article aims to empower unitholders of mutual funds to understand the process that goes into stress testing.
The author would request all unit holders of mutual funds, especially Small and Mid Cap funds of large Assets Under Management, to carry out stress testing of their mutual funds on their own to understand the correct liquidity position of the fund.
PS – The author is not associated with the Financial Services industry.
The author owns no “Small and Mid-Cap Mutual fund” in his portfolio.
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