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.
Liquidity in capital markets is like oxygen. You only notice its importance when it’s gone. – Source unknown.
About the author: This article is written by a freefincal reader who prefers anonymity.
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?
🔥Secure your future with our Robo-advisory tool trusted by over 3,500 investors and advisors. From effortless retirement planning to funding your children’s biggest dreams, turn your financial goals into reality. 🔥
Subscribe for money management solutions via email! (Link takes you to our email sign-up form) Join 32,000+ readers in our community.
👉 New Tool Alert! NaviPlan: A Privacy-Focused Multi-asset Tracker and Goal Planner 👈
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.
We are on Google News
Use this button to add freefincal.com as a preferred personal finance source on Google News.
Explore 1,400+ videos on YouTube!
Subscribe to get posts via email!
Join 32,000+ readers and get free money management solutions delivered to your inbox! (Link takes you to our email sign-up form)Join our WhatsApp Channel
Explore our products
🔥Join our community of 9000+ users! 🔥- Use our Robo-advisory Tool to create a complete financial plan! More than 3,500 investors and advisors use this! Use the discount code robo25 for 20% off. Plan your retirement (early, normal, before, and after), plus non-recurring financial goals (such as child education) and recurring financial goals (such as holidays and appliance purchases). The tool helps anyone aged 18 to 80 plan for retirement, plus six non-recurring and four recurring financial goals, with a detailed cash flow summary.
- Our Flagship Course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 3,500 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market conditions! Watch the first lecture for free! One-time payment! No recurring fees! Lifelong access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
- Join the freefincal investor circle! An exclusive space for investors, advisors, fintech employees and students to access financial planning and insurance tools, mutual fund and stock analysis tools, coding strategies and Excel macros for data extraction. 750+ members are now part of our investor circle.
- Increase your income by getting people to pay for your skills! More than 900 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner seeking more clients through online visibility, or a salaried individual looking for side or passive income, we will show you how to do it by showcasing your skills and building a community that trusts and pays you. (Watch the 1st lecture for free). One-time payment! No recurring fees! Lifelong access to videos!
- Portfolio Tracker! Track your mutual funds and stock investments with our Google Sheet!
- We also publish monthly screeners for
Our Podcast: Let's Get Rich With Pattu
On Spotify: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! On Audible: Listen to the Let's Get Rich with Pattu Podcast
Listen to the Let's Get Rich With Pattu podcast on YouTube.
Now watch Let's Get Rich With Pattu தமிழில் (in Tamil)!About The Author
Dr M Pattabiraman giving a lecture
- Dr M. Pattabiraman (PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras.
- He has over 14 years of experience publishing news analysis, research and financial product development. He has over 28 years of teaching and research experience. He is also a public speaker and keynote presenter.
- He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free, AUM-independent investment advice.
- Connect with him via @pattufreefincal on X LinkedIn YouTube
- Pattabiraman has co-authored three print books.
This book helps you ask the right questions and find the right answers. It also includes nine online calculators to create custom solutions.
(2) Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want. 
Both the boy and girl versions of "Chinchu Gets a Superpower".
Most investor problems stem from a lack of poor decision-making. We made bad decisions and money mistakes when we started earning, and we spent years undoing them. Why should our children go through the same pain? What is this book about? As parents, what if we had to groom one ability in our children that matters not only for money management and investing but for every aspect of life? My answer: Sound decision-making. So, in this book, we meet Chinchu, who is about to turn 10. The story follows what he wants for his birthday and how his parents plan it, while also teaching him key ideas about decision-making and money management. What readers say! 
Feedback from a young reader after reading Chinchu Gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from a young age. The importance of money management and decision-making based on their wants and needs. Very nicely written in simple terms. - Arun.
About freefincal & its content policy
Freefincal is a News Media organisation dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact Information: To get in touch, please use our contact form. (Sponsored posts or paid collaborations will not be entertained.)Our publications
- Your Ultimate Guide to Travel. This is an in-depth exploration of vacation planning, including how to find affordable flights, budget accommodations, and practical travel tips. It also examines the benefits of travelling slowly, both financially and psychologically, with links to relevant web pages and guidance at every step. Get the PDF for Rs 300 (instant download)
- How to profit from content writing: Our ebook is for those interested in getting a side income via content writing. It is available at a 50% discount for Rs. 500 only!