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 information. The primary disclosures have 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 day by day common traded volumes on each NSE and BSE with three-fold volumes.”
A number of enhancements and tips for conducting stress testing are required within the course of. The writer has outlined its strategies 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 buyers got here in for redemptions, how lengthy will it take for a fund supervisor to liquidate his holdings and, due to this fact, the variety of days to honour these redemptions?
Writer’s Views: Portfolio liquidity must be measured by the point it should take to liquidate the whole 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 buyers
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 need to maintain on to for an extended interval for higher returns. Usually, when redemption requests are positioned, a fund supervisor gained’t be chopping his most illiquid shares first; these will likely be wound up final. Because the stress take a look at is for eventualities of 25% or 50% redemptions, probably the most illiquid a part of the portfolio needn’t be touched.
Writer’s views: The philosophical argument in opposition to that is that outdated saying in English “A series is as robust as its weakest hyperlink”. Due to this fact, 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 likelihood 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 will not be the proper approach 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 situations and investor curiosity in particular person shares.
Writer’s views: Three months is just too brief for a development for use for interpolation or extrapolation.
Required Enhancements: Stress testing have to be finished for 1-year common commerce quantity
4.Three-month day by day common traded volumes on NSE and BSE with three-fold volumes.
Philosophy: Sometimes, when markets flip risky, 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 information exhibits that buying and selling volumes are round 3 times the typical prevailing volumes beneath stress.
Writer’s views: On the worst days, Monetary markets freeze and liquidity vanishes. The development that has been used to supply the argument that buying and selling quantity 3 occasions relies solely on post-COVID traits.
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 amount for calculation
5. A ten% participation
Philosophy: That is beneath the idea {that a} fund will solely have the ability to promote down 10% of the traded quantity by way of market gross sales in a day as a result of everyone seems to be scrambling to promote. That is simply an assumption.
Writer’s views: This can be a smart assumption for use for stress testing.
Abstract: This text goals to empower unitholders of mutual funds to know the method that goes into stress testing.
The writer would request all unit holders of mutual funds, particularly Small and Mid Cap funds of huge Property Beneath Administration, to hold out stress testing of their mutual funds on their very own to know the proper liquidity place of the fund.
PS – The writer will not be related to the Monetary Companies trade.
The writer owns no “Small and Mid-Cap Mutual fund” in his portfolio.
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