Liquidity Stress Tests for Small and Mid-Cap Mutual Funds

In a significant move aimed at enhancing transparency and safeguarding investor interests, the Association of Mutual Funds in India (AMFI) has directed asset management companies (AMCs) to conduct monthly liquidity stress tests for their small and mid-cap mutual fund schemes. The results of these tests are to be disclosed on the AMCs’ official portals and AMFI’s website by the 15th of each subsequent month, based on the preceding month’s data.

The decision comes in the wake of heightened retail investor interest in small and mid-cap stocks, which has led to froth in these segments of the market. Several fund houses have already taken steps to restrict lumpsum investments in their small-cap schemes, citing concerns over liquidity and potential risks to investors.

Understanding the Stress Test

The liquidity stress test is designed to highlight the illiquidity of stocks in which a mutual fund scheme has invested. It aims to reveal the level of free float in the scheme’s portfolio, which refers to the stocks that are freely available for trading on the stock exchange. Typically, shares owned by retail investors and not under any lock-in period are considered free float.

By disclosing the results of these stress tests, AMCs will provide investors with crucial information about the liquidity profile of their small and mid-cap schemes. This will enable investors to make more informed decisions and assess the potential risks associated with investing in these schemes.

Categorization of Small and Mid-Cap Funds

According to SEBI’s categorization of mutual fund schemes, mid-cap mutual funds are required to invest a minimum of 65% of their assets in mid-cap stocks, while the remaining 35% can be invested in other categories, such as small and large-cap stocks. Similarly, small-cap mutual funds must allocate at least 65% of their assets to small-cap stocks.

This categorization helps investors identify the schemes that align with their investment objectives and risk appetite. However, it is crucial for investors to understand the liquidity risks associated with these schemes, particularly in times of market volatility.

Redemption Timelines Vary Across Schemes

The stress test results released by mutual fund houses on March 15, 2024, have revealed significant variations in the redemption timelines of different small and mid-cap schemes. For instance, HDFC Mid-Cap Fund would take as long as 23 days to redeem 50% of its portfolio, while Axis Mid-Cap Fund would require only 12 days for the same.

Similarly, in the small-cap category, Quantum Small Cap Fund would take just one day to redeem 50% of its portfolio, while SBI Small Cap Fund would need a staggering 60 days to achieve the same. These differences highlight the importance of conducting liquidity stress tests and disclosing the results to investors.

Froth in Small and Mid-Cap Stocks

The recent surge in retail investor interest in small and mid-cap stocks has led to concerns about the sustainability of the rally and the potential risks involved. Many of these stocks have delivered exceptionally high annualized returns in the past few years, sometimes as high as 70%, attracting a large number of investors.

However, this increased demand has also resulted in froth in the market, with some stocks trading at valuations that may not be justified by their fundamentals. In such a scenario, liquidity becomes a critical factor, as it determines the ease with which investors can enter or exit their positions.

Restrictions on Lumpsum Investments

In response to the massive inflow of funds into their small-cap schemes, some fund houses have taken proactive measures to manage liquidity risks. These restrictions are intended to prevent a sudden influx of funds that could potentially destabilize the market and impact the liquidity of the underlying stocks. By limiting lumpsum investments, AMCs aim to ensure that their schemes can efficiently manage the inflow and outflow of funds without compromising on the interests of existing investors.

Month: Current Affairs - March, 2024