Despite limitations, Sebi-mandated stress tests on small, midcaps serve a purpose

The significant inflows into small-cap funds, nearly 15 times those into large-cap funds, coupled with the 33% surge in the Nifty Smallcap index over the past six months, underscore India’s strong economic performance. However, this surge in small company listings also harbours the risk of underperformance should GDP growth not align with investor expectations.

Nonetheless, the reliability of Sebi-mandated stress tests on small and medium cap stocks for producing accurate results has been questioned. So, have they caused unnecessary panic, or do they serve a purpose? The fact is, despite their limitations, they indeed serve a purpose

While mutual funds and industry observers have shown unease, and some critics have expressed angst, terming Sebi’s actions overly intrusive, stakeholders typically look to the regulator in times of distress. Therefore, Sebi is expected to continue advocating for these stress tests to become standard internal benchmarks. Above all, the protection of retail investors’ funds remains a paramount concern.

The stress tests simulate scenarios to evaluate a fund’s capacity to effectively manage simultaneous redemption requests. These mandated stress tests on mid- and small-cap mutual fund schemes have uncovered potential higher risks for larger players compared to their smaller counterparts. Sebi aims to mitigate the rapid influx of retail investments into mid and small caps by requiring mutual fund houses to issue stress test reports fortnightly, promoting equitable treatment of investors amid heightened market volatility.

The watchdog has emphasized the importance of mutual fund houses releasing stress test reports and maintaining fair treatment of investors, particularly during market turbulence.

Lower liquidity of small caps presents challenges in swift selling compared to mid to large caps, thus prolonging the redemption process in small-cap funds. Unlike highly sought-after stocks of large companies, some small company stocks may lack popularity or attract fewer buyers, leading to delays in finding suitable buyers at favourable prices. Additionally, selling large volumes of small-cap stocks can pose logistical difficulties.

Critics have argued that imposing stress tests on small-cap and mutual fund schemes unnecessarily destabilizes the market, contending that the tests lack a rational basis. They point out the unrealistic assumption that liquidity remains constant and the problematic reliance on past data, ignoring the potential for sudden liquidity crises in specific stocks. Liquidity disappearance does not adhere to predefined timeframes such as 6 days or 14 days but can occur instantaneously. Therefore, relying solely on extrapolative analysis may yield unreliable results.

Fair point. But. Yes, there is a but. Fact is, that fund managers have disclosed the timeframes that they will require to liquidate or redeem 25% and 50% of their small-cap and mid-cap portfolios, respectively. The findings are concerning, as some major asset managers may need up to 60 days to fulfil investor redemption requests, even after considering available cash reserves and highly liquid large-cap holdings. This serves investors quite well, as they should know it as part of their investment guidance.

Equity values can plummet rapidly, even for liquid stocks, particularly during company crises. In such instances, a stock could lose 40-60% of its value within a week, assuming lower circuit application. Mutual funds holding such stocks face heightened stress across their entire portfolio. Therefore, the market regulator must in fact devise strategies to manage systemic redemption pressures for stressed mutual funds. This entails establishing thresholds for liquidation and developing parameters and guidelines to identify stressful redemption events.

Risk management requires detailed scenario analysis and a robust playbook. In the realm of fund investment, while risk mitigation is crucial, robust risk management remains paramount. In 2023, small-cap and mid-cap schemes garnered 40% of total net inflows into active equity schemes, receiving ₹64,000 crore out of a total inflow of ₹1.6 trillion. To mitigate risk, some fund houses have opted to restrict inflows into their schemes.

Continuous monitoring and adaptation by regulators and industry stakeholders are essential to effectively manage risks and safeguard investor assets. Despite efforts to instil investor confidence over the years, any adverse incident could undermine faith in the sector.

After all the regulator did sound this out upfront. “I am not satisfied with the data right now. More work is needed. It has to be a combination of looking at stress testing numbers and also figuring out what the industry will do if certain thresholds are breached,” the chairperson of Sebi had said at an industry conference in January 2024.