Stress testing

Evaluating equity funds is a good idea

The Securities and Exchange Board of India (Sebi) is looking to comprehensively stress-test equity mutual fund schemes and put in place mitigating measures to handle potentially dangerous situations. This is a relatively new initiative on the part of the regulator, but it follows the first round of stress tests, which is said to have resulted in unsatisfactory outcomes. There is a fair logic behind the policy move of instituting more comprehensive stress testing. Equity funds continue to draw huge inflows and most of these emanate from retail investors — indeed, the bulk of the equity assets under management is held in retail folios. Moreover, continuing large inflows force fund managers to commit to buying stocks within their mandates, even though valuations are high across most segments of the market due to a sustained increase in stock prices.

If there is a crash, it may lead to a spike in redemption demands, and funds may, in turn, find it difficult to meet redemption pressures since the money has to be returned quickly. If funds are forced to sell in a falling market to meet redemption demands, the selling pressure could lead to a cascade of further losses, causing a bad feedback loop of more redemption demands, further enforced selling, lower prices, and so on. If it happens at all, it is likely to be especially damaging to unitholders in schemes that track smallcap and midcap stocks because smaller scrips tend to have less liquidity. Hence, a large volume of institutional sales exerts a greater downward pressure on prices. Smaller stocks outside the futures & options segment also have circuit breakers that can lead to trading freezes and put a crimp in redemptions as trades become impossible.

Several asset-management companies have proactively put in place measures against such a scenario by, for example, refusing to take lump-sum investments in smallcap and midcap funds. Systematic investment plan commitments are easier to manage, both in terms of deployment in the market and possible redemptions. But the regulator is right to ask for a more comprehensive set of tests to establish which schemes may be more at risk, and to mark “trigger points” where redemption pressures could raise red flags. Mitigation measures could include judicious deployment of funds to prevent forced selling in such situations. At need, Sebi could also consider other measures like extending the period of redemption or allowing arranging short-term funds to meet the redemption demand.

Another question that arises is that of transparency. There are pros and cons. The stress-test criteria, assumptions and formats may be complex and opaque. Should the regulator consider publishing stress-test results if funds come close to the red zone? This would allow smart investors to redeem units in an orderly fashion, but it could also result in panic. But if results are not made public, it would not help investors and defeat the purpose. The regulator will have to take a call in this context. Stock markets are cyclical. Every bull-market is followed by a correction, and that correction may be extremely steep. Mutual funds are an important institutional segment and since they are directly answerable to retail investors, redemption pressures can build up quickly in the event of sentiment turning sour. It is better to consider such situations and be prepared.