Market regulator Sebi planning comprehensive stress tests of equity schemes

Initial round done, more tests planned, particularly of schemes with high, small and midcap exposure

The Securities and Exchange Board of India (Sebi) is in active discussion with the mutual fund (MF) industry to do a comprehensive stress test of equity schemes and figure out measures to tackle situations when the test results indicate red flags, chairperson of the markets regulator Madhabi Puri Buch said here on Friday.

The markets regulator reviewed reports of the first round of stress tests by fund houses recently but the data provided was not satisfactory, said Buch at a summit on capital formation by the Association of Investment Bankers of India (AIBI).

"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," she said, adding that this exercise may continue for a few more rounds.

The move comes at a time when investors are putting in large sums of money into smallcap and midcap schemes, despite elevated valuations. In the calendar year 2023, smallcap and midcap schemes cornered 40 per cent of the total net inflows into active equity schemes. They received Rs 64,000 crore of total inflows of Rs 1.6 trillion.

Apart from the risk of sharper corrections vis-a-vis largecap stocks, smallcap shares also face liquidity risks as the volumes traded tend to be relatively thin.

Given that MFs have to pay back investors within a couple of days of notice, risks on the liquidity side can become a challenge for MFs to meet redemptions, especially during periods of distress. During stress testing, MFs evaluate if they will be able to meet large redemption pressures, going by the recent liquidity in the stocks that they hold.

To mitigate risk, some of the fund houses have already taken a call to limit inflows into their schemes. SBI MF has not been taking lumpsum inflows into smallcaps schemes for years now, while Tata MF and Nippon MF stopped taking money through the lumpsum route last year.

Several analysts have turned cautious on the midcap and smallcap space after the sharp run-up in 2023. The Nifty Midcap 100 and the Nifty Smallcap 100 gained 46.6 per cent and 55.6 per cent, respectively in 2023 compared to a 20 per cent rise in Nifty 50, according to data from Bloomberg. Following the sharp rally, the mid and smallcap indices now trade at a premium to largecaps.

According to senior MF executives, large redemptions should not be an issue even for a smallcap fund. “At least for withdrawals amounting to 20-25 per cent of the assets under management (AUM), given that they have significant allocation in largecap and midcap stocks and cash in the portfolio,” explained one senior official.

Sebi regulations allow up to 35 per cent exposure to midcaps and largecaps in smallcap schemes.

Speaking to reporters, the Sebi chief said the stress tests are a normal part of the regulator’s job. "Whenever there is a significant movement, it is our job to examine possible risks. That examination should be based on data. Stress testing naturally has to happen at the portfolio level," she said.

According to MF officials, the tests were limited to players with large exposure to smallcap and midcap space and the smaller fund houses may be asked to share stress test reports in later rounds.

It is mandatory for the industry to stress test debt funds and there are plans to make it a regular feature for equity schemes as well, especially those with higher exposure to midcap and smallcap stocks, said an MF executive.