In early 2024, the Securities and Alternate Board of India (SEBI) mandated that each one mutual fund homes disclose the outcomes of stress assessments for his or her small-cap and mid-cap schemes. Following this directive, the Affiliation of Mutual Funds in India (AMFI) required fund homes to publish these stress take a look at outcomes by the fifteenth of every month based mostly on the previous month’s knowledge. The primary disclosures had been made on March 15, 2024.
Liquidity in capital markets is like oxygen. You solely discover its significance when it’s gone. – Supply unknown.
In regards to the writer: This text is written by a freefincal reader who prefers anonymity.
Stress take a look at standards – “Professional-rata liquidation of 25% / 50% of the portfolio, after eradicating the underside 20% of the portfolio based mostly on scrip liquidity, contemplating 10% participation quantity of three-month each day common traded volumes on each NSE and BSE with three-fold volumes.”
A number of enhancements and pointers for conducting stress testing are required within the course of. The writer has outlined its recommendations together with the rationale for a similar under.
1 Professional-rata liquidation of 25% / 50% of the portfolio
Philosophy: These are eventualities for which mutual funds’ liquidity is being examined. In eventualities the place 25% or 50% of traders got here in for redemptions, how lengthy will it take for a fund supervisor to liquidate his holdings and, subsequently, the variety of days to honour these redemptions?
Creator’s Views: Portfolio liquidity needs to be measured by the point it’ll take to liquidate the complete portfolio i.e. 25%/ 50% / 75% /100%.
25% and 50% Redemption eventualities aren’t the worst-case eventualities
On the worst day of a liquidity disaster 100% liquid portfolio would imply appropriate “transactable NAV” for incoming and “redeemable NAV” for outgoing traders
Required Enhancements: Professional-rata liquidation of 25% / 50% / 75% / 100% of the portfolio
2 Eradicating the underside 20% of the portfolio based mostly on scrip liquidity
Philosophy: That is to permit room for a fund supervisor to carry on to illiquid shares that he/she might imagine are prime quality or would wish to maintain on to for an extended interval for higher returns. Usually, when redemption requests are positioned, a fund supervisor gained’t be slicing his most illiquid shares first; these might be wound up final. Because the stress take a look at is for eventualities of 25% or 50% redemptions, essentially the most illiquid a part of the portfolio needn’t be touched.
Creator’s views: The philosophical argument towards that is that outdated saying in English “A sequence is as robust as its weakest hyperlink”. Subsequently, a mutual fund portfolio is as liquid as its most illiquid securities.
Eradicating the underside 20% of the portfolio based mostly on script liquidity provides a distorted model of the illiquidity of the portfolio.
There’s a probability the place in a mutual fund portfolio might have many illiquid securities as the highest 50% of the portfolio.
Required Enhancements:Eradicating the underside 20% of the portfolio based mostly on scrip liquidity shouldn’t be the right solution to stress take a look at an MF.
3 Three-month common commerce quantity
Philosophy: That is only a cheap interval that displays the prevailing market circumstances and investor curiosity in particular person shares.
Creator’s views: Three months is just too brief for a development for use for interpolation or extrapolation.
Required Enhancements: Stress testing should be executed for 1-year common commerce quantity
4.Three-month each day common traded volumes on NSE and BSE with three-fold volumes.
Philosophy: Usually, when markets flip unstable, buying and selling volumes spike. So, when markets go down, even when the inventory value goes down, extra shares get traded as individuals scramble to purchase and promote. Previous knowledge reveals that buying and selling volumes are round thrice the typical prevailing volumes below stress.
Creator’s views: On the worst days, Monetary markets freeze and liquidity vanishes. The development that has been used to offer the argument that buying and selling quantity 3 occasions relies solely on post-COVID tendencies.
Required Enhancements: For proper stress testing, we must always take 1-year Common buying and selling quantity on each NSE and BSE with ½ the quantity for calculation
5. A ten% participation
Philosophy: That is below the belief {that a} fund will solely be capable to promote down 10% of the traded quantity by means of market gross sales in a day as a result of everyone seems to be scrambling to promote. That is simply an assumption.
Creator’s views: It is a smart assumption for use for stress testing.
Abstract: This text goals to empower unitholders of mutual funds to grasp the method that goes into stress testing.
The writer would request all unit holders of mutual funds, particularly Small and Mid Cap funds of enormous Property Below Administration, to hold out stress testing of their mutual funds on their very own to grasp the right liquidity place of the fund.
PS – The writer shouldn’t be related to the Monetary Companies business.
The writer owns no “Small and Mid-Cap Mutual fund” in his portfolio.
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