Can your mid-cap and small-cap mutual funds handle stress?

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The mid- and small-cap show continues its blockbuster spree on Dalal Street. Mutual fund investors continue to pile on to this runaway train. But the market watchdog Sebi is sniffing some potential for trouble brewing within this heated space. As per reports, it has called for extensive stress tests of all mid-cap and small-cap equity funds.

Essentially, the regulator wants to ascertain whether mid-cap and smallcap funds will be able to withstand sudden outflows in case of steep correction in stock prices, without incurring heavy impact cost. Liquidity is critical in mid- and small-cap funds. It refers to how easily underlying shares can be bought or sold in the market without significant loss of value. Apart from a few top-tier names, most stocks in this segment do not enjoy healthy trading volumes on the exchanges at all times. When conditions are good, these are awash with liquidity. But when the tide turns, liquidity can dry up very rapidly. A fund that houses large chunk of its portfolio in such stocks becomes vulnerable. The fund performance starts to deteriorate. The actual realisable NAV (net asset value) becomes lower than its calculated NAV. If faced with large redemptions in this scenario, fund managers find it difficult to quickly liquidate a portion of the portfolio. “In adverse conditions, several stocks from this space find no buyers, but many sellers. It creates panic among investors which can hurt funds badly,” observes Arun Kumar, Head – Research, FundsIndia.

The perception of dark clouds gathering on the horizon for mid and small caps is not unfounded. According to a DSP Mutual Fund report, there is an unsettling calm prevailing in this segment. The number of days the mid- and small-cap indices have risen by 1% or more neared the previous best years in 2023. The small-cap index enjoyed the second-best year ever in terms of number of days the index dropped during the year.

2023 was among the calmest years for the mid- and small-cap indicesSuch years are typically followed by heightened volatility and drawdowns.

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The mid-cap index had the third-best year. As per the report, such calm has historically been followed by heightened volatility and drawdowns in subsequent years. The regulator wants fund houses to be prepared if history repeats itself. Abhijit Bhave, MD and CEO, Equirus Wealth, remarks, “The regulator is doing the right thing. It is akin to preventive maintenance. In a bad year, investors will suffer if liquidity deteriorates.”

So, are existing mid-cap and small-cap funds ill-prepared for this scenario? Most funds in these categories are known to keep adequate cash to meet outflows. There is no minimum regulatory cash requirement.

Eight small-cap funds and 17 mid-cap funds currently have less than 3% parked in cash and equivalents. Further, these funds have the room to park up to 35% of their assets in large-cap stocks, which enjoy better liquidity. Only six of 29 mid-cap funds have less than 10% allocation to large caps. However, several small-cap funds are light on large caps, while also running a low cash position. Any upheaval in the mid- and small-cap arena may leave certain funds vulnerable. Kumar avers, “Most funds have adequate liquidity built in for a spike in redemptions. But they may not have factored in extreme redemption pressures.”

As per a Reuters report, after initial round of stress tests, the watchdog has asked funds to test for more adverse scenarios. If Sebi finds funds lacking on the liquidity front, it may follow up with measures. For instance, asking funds to shore up their portfolio with a minimum level of cash or large-cap exposure may be on the anvil. However, this may have undesirable sideeffects, say experts. While resilience of the funds will improve, fund return may end up getting diluted in the long run. Bhave asserts, “Some fund managers prefer to remain fully invested to capture full upside in the market. Further, tying down a portion of mid- or small-cap funds in large-cap stocks goes against the principles of clearly defined fund mandates.”

To be sure, liquidity risk in equity funds gets captured in the riskometer—a framework introduced to specifically alert investors of deteriorating risk profile in any fund. However, this tool remains ineffective in its present form. Under the existing construct, every individual security held in a fund’s portfolio is assigned a value based on three distinct parameters—market capitalisation, volatility and impact cost. After aggregating the risk values, the fund is assigned an overall risk level ranging from ‘low’ to ‘very high’. The impact cost value directly captures the liquidity risk in a fund. If the fund contains several stocks with poor liquidity (high impact cost), it will translate into a high liquidity score (lower the better). Given that it is updated monthly, one would expect that the riskometer is well placed to alert of any slippage in liquidity profile of a fund. Alas, as it stands, the riskometer reading for all equity funds, including large-cap funds, already points to the highest level of risk. In the event of a big selloff in mid- and small-cap space, the impact cost will start rising quickly, which will get reflected in a higher liquidity score for funds dabbling in illiquid stocks. But given that the funds have already hit the ceiling in risk score, such deterioration in liquidity profile will not get flagged. The riskometer doesn’t provide risk score for each parameter separately either.



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