Redemption risks

Stress tests highlight risks in smallcaps

Following the Securities and Exchange Board of India’s (Sebi’s) request to the Association of Mutual Funds in India (Amfi), mutual funds with midcap and smallcap mandates have started instituting stress tests as well as restricting fresh inflows. The market regulator is concerned about “frothy” valuations in these segments, following a surge in inflows. In FY24, over Rs 64,000 crore has been invested in these smaller stocks. In these stress tests, funds use a specified methodology to gauge how long it would take them to sell 25 per cent and 50 per cent of their holdings. The funds will continue to conduct stress tests every month and publish the results in mid-month. These stress tests assess how badly funds and the stock market would be affected if there were mass redemption demands. According to Sebi regulations, at least 65 per cent of assets under management (AUM) must be invested in the stated market segment of a fund’s mandate. The funds under review are open-ended and, therefore, could conceivably face big redemption demands, forcing them to sell equity holdings in order to return cash to unit-holders. Moreover, this redemption is supposed to be done within three working days under normal circumstances.

In practice, it’s unlikely that an open-ended fund would have to liquidate half its portfolio — it would take a significantly big trigger for such mass redemptions. Indeed, even 25 per cent liquidation would imply a massive redemption demand. However, if three days are kept as the benchmark, most of the 28 midcap funds that have reported stress tests so far seem capable of comfortably liquidating 25 per cent of their portfolio within three days. However, nine of these would need more than three days and some outliers would require much more time. For example, one fund with an AUM of over Rs 60,000 crore assesses that it would need around 12 days to liquidate 25 per cent of its portfolio.

The concerns about liquidity are more significant in the smallcap segment. Smallcap liquidity is often quite low and this can be seen in a universe of 27 smallcap funds which have reported test results so far. Of these, only 14 can liquidate 25 per cent of their holdings within three days. One fund with an AUM of Rs 25,500 crore would require a month to liquidate 25 per cent of holdings and 60 days to liquidate 50 per cent. It may be noted that the more illiquid a portfolio is, the more the likely impact costs. That is, given a high volume of sales, share prices would drop considerably since a large supply of shares would be difficult for the market to absorb. This leads to the implication that, in a situation of mass redemption, the possibility of capital losses and price volatility would increase. These stress tests are only indicative.

In a real-world situation, it is unlikely that such liquidation would be necessary. However, these results do indicate that there is greater risk in smallcap funds, especially in funds with a low liquidity profile. The stress tests are an indication for both fund houses and investors. Fund houses may contemplate inflows only to an extent that is manageable. For investors, it once again underlines higher risks in smallcaps. Even while investing through mutual funds, investors must aim for a diversified holding.