The results have come in from Sebi-mandated stress tests for mid and small cap funds. Days to liquidation range from 12 days for Franklin Smaller Companies Fund to liquidate 50% of the portfolio to 60 days for SBI Small Cap Fund. Mint decodes what the data mean for you.
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Why did Sebi mandate the stress test?
Small and mid cap funds have seen a huge rise in flows over few years on the back of high returns. Assets under management (AUM) of small-cap funds rose from ₹1.06 trillion at the end of Jan 2022 to ₹2.49 trillion at the end of Feb 2024. For mid-cap funds, the AUM has risen from ₹1.58 trillion at the end of Jan 2022 to ₹2.95 trillion at the end of Feb 2024. Thus it has more than doubled for small cap funds and grown 86% for mid cap funds. The small cap returns in the past year alone has been 46.73%. All this has raised concerns around the ability of funds to handle a deluge of money, especially in a space which tends to have less liquidity.
What methodology was used for the tests?
According to an AMFI circular, asset management companies must rank stocks in descending order of liquidity. They must assume volumes that are 3 times the ordinary trading volumes in a stock and assume that they are able to liquidate the stock up to 10% of this volume per day. The reasoning appears to be that volumes spike up during times of panic. Next, they must exclude the 20% most illiquid stocks. Using data for the 21st most illiquid stock, they must estimate how long it will take to exit 25% and 50% respectively of the portfolio. Funds have to give the days to liquidation.
Are there issues with the methodology?
There are some pointers which can make the results look rosy. First is the exclusion of 20% most illiquid stocks—the stress test is not on 100% of the portfolio. Second is the assumption of 3x volumes during panic selling. Such a surge may not happen. Third, the test tells you about the ability of the scheme to liquidate its portfolio—not how much the asset value can fall by.
Should you be worried?
No. The issue of poor liquidity came up in 2020 when Franklin Templeton faced heavy redemptions on six of its debt funds and the company took a sudden decision to wind up the schemes. Investors were taken aback and the winding up ran into litigation. The process of liquidation was eventually handed over to SBI Mutual Fund. Investors also got back most of their money, but after having to wait for a few years. This happened with debt but it has never happened with equity in India.
What can you as an investor do?
The decision to invest in large or mid- or small-cap funds is a tricky one. It involves market timing— you are essentially predicting which segments will perform when. For example, mid and small cap stocks were outperformers in 2017, but underperformed in 2018-20 before reviving in post- pandemic 2022-23. It is smarter to leave this decision to a seasoned fund manager by investing in flexicap funds, which can set the allocation between large, mid and small caps as per the fund manager. This is also tax efficient.