Explained: Should smallcap funds' stress-test results concern you?

Recently, the Securities and Exchange Board of India (Sebi) conducted a stress test on smallcap mutual funds in India. Think of it like a fire drill for your investments. The market regulator wanted to see if these funds could handle a situation where many investors suddenly wanted their money back (redemptions). Here's the catch: smaller companies, which these funds often invest in, can be trickier to sell quickly compared to larger firms.

Fund houses have started disclosing the result of the stress test for their midcap and smallcap schemes. They'll be revealing the test result by the 15th of every month. 

Watch: How long will small and midcap stock downturn continue?

What is a stress test?
This test will check how quickly smallcap and midcap funds can sell 25 per cent and 50 per cent of their holdings. 

 

Why is there a need for a stress test? 

Sebi and  the Association of Mutual Funds in India (Amfi) have been concerned about the large quantities of investor money - around Rs 64,000 crore -- being poured into midcap and smallcap funds.

"As a result, the regulators directed fund houses to run a liquidity analysis based on a specific methodology to evaluate how many days it will take for any fund to liquidate 25 and 50 per cent of its portfolio. This test will indicate how quickly these funds can sell their holdings if investors want to exit their investments en masse during a market crash.For the uninitiated, mid- and smallcap funds face issues when their asset size increases. One key concern during such times is portfolio liquidity. Meaning, these funds can find it tough to sell their stake in the face of high redemption pressure from investors," said Value Research in a note.

The results revealed that the top six smallcap funds in India might take over 20 days to liquidate 50 per cent of their assets.

SBI MF, which manages the third-largest smallcap scheme with a corpus of Rs 25,500 crore, estimates it would need 60 days to sell half of the assets of the fund and 12 days to liquidate a quarter of it. However, the fund house is confident that the scheme can handle a surge in redemptions, if any. 

Nippon India MF’s smallcap schemes, which is the largest in the category with an AUM of Rs 46,000 crore, will need 27 days to liquidate half of the portfolio. 

Apart from SBI MF, HDFC, Tata, Kotak, and DSP Mutual Fund will need over 30 days to sell 50 per cent of their smallcap fund portfolios. Tata and DSP manage their smallcap funds with a “true-to-the-label” strategy as they invest nearly 90 per cent of the corpus in smallcap stocks vis-a-vis 65-80 per cent allocation in the case of other large schemes.

All the schemes having less than Rs 5,000 crore AUM have said that 50 per cent of the assets can be sold within five days.

This news might leave some investors scratching their heads. Let's break down the implications and what it means for you:

Selling a large chunk of small-company stocks (holdings) in a short period can be challenging. 

1. Less liquidity: Smallcap stocks are generally traded less frequently than largecap stocks. This means finding enough interested buyers to sell a significant portion of the holdings quickly can be difficult.
2. Price impact: Selling a large amount of a stock at once could drive down the price.
3. Finding right buyer: Not all investors are interested in buying smallcap stocks. It might take time to find institutional investors or other funds willing to take on these holdings.

The Sebi stress test results highlight the potential liquidity risk associated with smallcap funds. Here's how it can affect you:

1. Access to Your Money: If you invested in a smallcap fund and suddenly need your money back, it might take longer than expected to get it. This could be a concern if you have short-term financial goals.
2. Market Volatility: During periods of market turmoil, investors might be more likely to redeem their holdings. This could put additional pressure on the fund's ability to sell assets quickly.

What do MFs say?

While the overall results show a longer liquidation time for top smallcap funds, individual performances varied. Some funds might be more efficient than others in selling their holdings. Investors should look for specific disclosures from their chosen fund house:

Here's what you can do:

1. Diversify Your Portfolio: Don't put all your eggs in one basket. Invest in a mix of asset classes, including large-cap funds, debt instruments, and gold, to balance risk and potential returns.
2. Choose Funds Wisely: Look for funds with a strong track record, clear investment strategies, and transparency regarding liquidity.
3. Match Your Investment Horizon: If you need easy access to your money in the short term, smallcap funds might not be the best choice.

"Be on the safer side and maintain a long-term investment horizon of at least seven years for mid- and smallcap funds. Avoid allocating emergency funds to these funds. Allocate 20-30 per cent in midcap and 10-20 per cent in smallcap funds. Rebalance regularly to maintain the desired allocation," said Hrithik Madan of Value Research.