Is Mutual Fund Stress Test Adding to Your Mental Stress?

In the last few days, the media has been abuzz with the word “stress test.” It is the talk of the town in the investment world. Due to this, the retail investors are getting anxious about it. 

So, let us simplify this issue and try to understand how it will impact retail investors and what they should do at this juncture. 

Before understanding the stress test of mutual funds, let us run through this scenario.  

1. A year ago Anita invested Rs. 10 Lakh in small and mid-cap funds. 

2. Today, the market value of her portfolio is Rs. 13 Lakh, a gain of 30% in just one year. She is delighted.

3. The next day, sentiment changed, and the market crashed.

4. She gets into a panic and decides to exit her portfolio. 

5. She submits a redemption (sell) request. Ideally, she should be able to sell her funds immediately and receive Rs. 13 Lakh in three working days.

6. However, due to poor liquidity, the AMC (Asset Management Company) is not able to sell the stocks in the portfolio.

7. Meanwhile, the market is spiraling downwards every day.

8. Her portfolio is depleting with each passing of the day increasing her anxiety. 

9. Finally, the redemption request was successfully executed on the fifth day.

10. But Anita received only Rs. 9 Lakh instead of Rs. 13 Lakh.

11. A gain of Rs. 3 Lakh turned into a loss of Rs. 1 Lakh. 

12. She is still wondering, “Why this has happened?” 

Welcome to the ruthless world of the stock market!

If you think that you will SIP and sleep peacefully then you are asking for trouble.

This is the precise reason, why SEBI (Securities and Exchange Board of India) instructed AMFI (Association of Mutual Funds in India) to direct all AMCs to conduct stress tests of mid and small-cap funds and submit the report.

What is the mutual fund stress test?

The stress test is a risk management technique. It tests the robustness of the portfolio under different market conditions like: -

1. Lack of Liquidity

2. Economic recession/slowdown

3. Market sentiments

4. Black swan events

So, from the industry perspective, it is a good thing. It provides mutual fund managers an insight into how their folio will behave under stressful market events. And this will empower retail investors to make informed decisions.

Why stress test now?

SEBI has observed that there is a froth building up in mid and small-cap funds. That means a lot of retail investors have invested in these funds and due to this the valuation has skyrocketed. Herd bias and irrational exuberance are two widely discussed human biases in behavioral finance. We are witnessing both of these now. And that is the reason SEBI wants retail investors to be careful about it. 

SEBI as a regulator is proactively handling this issue for the benefit of retail investors. This is a welcome step. AMFI has directed AMCs to disclose various parameters on the 15th of every month. The parameters include liquidity, portfolio turnover, standard deviation, and Beta among many others.

As depicted in the scenario above, liquidity impacts the portfolio harshly. Hence it is the critical parameter to watch out for. AMFI has asked AMCs to inform how many days will it take to liquidate the 25% and 50% portfolios.

Let us take a look at the liquidity data of a few AMCs:-  

Sl No	AMC	No. of days to liquidate 25% portfolio	No. of days to liquidate 50% portfolio
1	Edelweiss Small Cap Fund	2	3
2	Edelweiss Mid-Cap Fund	1	2
3	Nippon Small-Cap Fund	13	27
4	Nippon Mid-Cap Fund	4	7
5	HDFC Small-Cap Fund	21	42
6	HDFC Mid-Cap Fund	12	23
7	SBI Small-Cap Fund	30	60
8	Quant Small-Cap Fund	3	6
9	Quant Mid-Cap Fund	11	22
10	Tata Small-Cap Fund	18	35
11	Tata Mid-Cap Fund	2	3

The data shows that it may take two to thirty days for the redemption of 25% small-cap portfolio and two to sixty days for a mid-cap portfolio. Hence, if the portfolio is not managed diligently and professionally, this may create stress among retail investors.

What you should do now???

The stock market is driven by sentiments. Greed and fear are the only two factors that drive the market. If you understand that, half the battle is won.

Adhere to the following time-tested wisdom, and you will be better off:-

1. Do not press the panic button and sell your folio tomorrow.

2. Do not stop your SIPs.

3. Do not invest lumpsum money now. Invest through the STP (Systematic Transfer Plan) route.

4. If your MF portfolio is highly tilted towards small and mid-cap funds then there is a need to rebalance your portfolio. Move out slowly to safer heavens of large-cap and multi/flexi-cap funds.

5. Focus on risk, not on returns.

6. Avoid mimicking the herd.

7. Avoid irrational exuberance.

8. Diversify and rebalance your portfolio periodically.

9. Say no to instant gratification.

10. Be a long-term investor.

11. Improve your financial behavior.

And if you cannot handle all these on your own, it is prudent to avail the services of those whom you can trust. 

Warren Buffet said, “Risk comes from not knowing what you are doing.”