What you need to know about small cap mutual fund stress tests

Published: March 16, 2024 at 6:00 am

In this article, we explain in simple terms what a mutual fund stress test is and what investors need to appreciate while investing in mutual funds, especially small cap mutual funds.

If you have not seen the movie Margin Call, I strongly suggest you do so after reading this article. You could appreciate the situation better if you have already seen it. Demand vs supply forces determine the price of a stock, bond, or commodity in the market.

If buyers exceed sellers, then the price moves up and vice versa. An excellent book to appreciate these dynamics is Bulls, Bears and Other Beasts: A Story of the Indian Stock Market.

What happens during a market crash? Everyone wants to get out, so sellers far exceed buyers. And the sellers are happy to pay any low price that the buyer demands to get out. The more the sellers, the more the price gets driven down.

In a mutual fund, market crashes result in a risk that very few people seem to acknowledge – redemption pressure. As more and more unit holders want to exit the fund, the fund manager will have to sell more and more securities at a lower and lower price. So, the NAV could take a larger hit than representative broad market indices.

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥

This happened in March 2020 when Franklin closed six debt funds because the underlying bonds could not be sold in the open market. While investors focused on what Franklin Templeton Indian did or did not do or should have done, the underlying risk – redemption pressure or liquidity risk got sidelined.

The same situation can also occur in any equity fund, not just small cap funds, just that the risk is highest in small cap, the mid caps come next and then the large caps. This liquidity risk can evaluated with a metric known as the impact cost.

If I want to buy/sell one stock, there could be a small, even negligible, difference between the buying price and selling quoted. As the number of stocks I want to buy/sell increases, the price difference also increases. The impact cost measures this.

What is impact cost?

The following example has been derived from the NSEs impact cost definition page. Suppose the stock exchange order book looks like this at some instant.

QuantityBuy PriceSell Price

The quantity of shares for buying and selling will differ, but we have assumed it to be the same to keep things simple. Suppose I want to buy 2000 shares. Ideally, I should be able to sell all of them at the selling price of Rs. 102. Since the buying price is Rs. 100, the bid-ask spread is only Rs 2. So, we first define the ideal buying price as (102+100)/2 = 101

However, I can only buy 1000 shares in one lot at Rs. 102. The second lot of 1000 shares will be purchased at Rs. 103 (assume instant buys). So the average buying price for this trade is:

[(1000 x102) + (1000 x 103)]/2000 = 102.5

This Rs. 102.5 is 1.5% higher than the ideal buying price of Rs. 101. This 1.5% is known as the impact cost (for buying).

Impact cost is dynamic and depends on the quantity of shares involved in the transaction. There is a separate impact cost of buying and selling. The exchange can impose a penalty if the stock is not liquid enough, resulting in a higher cost.

The impact cost for selling will increase with a decrease in market capitalization. This is the proper way to differentiate large, mid, and small cap stocks. This is an analysis done in 2019. Things have likely improved now, but don’t set the expectations too high – Warning! Even “large cap” stocks are not liquid enough! Can you handle this?

So when the market falls, and investors want to pull out the funds, all funds will suffer to different extents just that it would be easier for a large cap fund manager to handle redemptions (sell stocks and turn them into cash for disbursal) than a small cap fund manager.

So, what do these stress tests tell us? Not much. We will only know how much the NAV will fall when the market falls. Simulations cannot replicate real stress on volume and liquidity. How long it would take theoretically or even practically for a fund manager to sell 25% or 50% of assets is of little use to investors.

During the market crash, they will turn from “long term” investors to “I want my money back” faster than the flip of a switch. The real stress test is education about risk and expectations. Otherwise, experience will teach us some hard lessons. It is immature to assume one can compensate for a low income by seeking a higher return. See: Is there any proof small cap mutual funds would outperform in the long term?

Regular readers may know that freefincal has always opposed investing in small cap mutual funds. Due to their highly volatile nature, returns can quickly swing from spectacular to disastrous and are most impacted by sideways market movements.

Investing in a flexicap fund with a “small” exposure to these funds is a relatively better idea. If you “must” invest in a small cap fund, then have only a small exposure and whenever you feel the gains are spectacular, redeem some amount and shift to equity or fixed income as per your asset allocation.

These are some of our earlier work on small cap funds:

So, if you are already invested in small cap funds and are wondering what to do, here are our suggestions: Is it time to exit small cap mutual funds? (Article dated March 5th 2024).

Do share this article with your friends using the buttons below.

🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
Follow Freefincal on Google News
Follow Freefincal on Google News
Subscribe to the freefincal Youtube Channel. Subscribe button courtesy: Vecteezy.
Subscribe to the freefincal Youtube Channel.
Follow freefincal on WhatsApp Channel
Follow freefincal on WhatsApp
Podcast: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! 
Listen to the Lets Get Rich with Pattu Podcast
Listen to the Let's Get Rich with Pattu Podcast
You can watch podcast episodes on the OfSpin Media Friends YouTube Channel.
Lets Get RICH With PATTU podcast on YouTube
Let's Get RICH With PATTU podcast on YouTube.
🔥Now Watch Let's Get Rich With Pattu தமிழில் (in Tamil)! 🔥
  • Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
  • Have a question? Subscribe to our newsletter using the form below.
  • Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!

About The Author

Pattabiraman editor freefincalDr 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 ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 3,000 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 condition is!! Watch the first lecture for free!  One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course!  Increase your income by getting people to pay for your skills! More than 700 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 who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!   
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Both boy and girl version covers of Chinchu gets a superpower
Both the boy and girl-version covers of "Chinchu Gets a superpower".
Most investor problems can be traced to a lack of informed decision-making. We made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So, in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it, as well as teaching him several key ideas of decision-making and money management, is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
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 their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization 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: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)