MF Stress Test: Why it matters and should investors be worried?

Sebi is concerned about a potential scenario wherein market sentiment turns and there are sudden redemptions and mutual funds are unable to honour redemption requests.

Come March 15, mutual funds are supposed to share Stress Test report on the ability of small- and mid-cap fund schemes to meet any sudden redemptions owing to adverse market conditions. Conversations relating to the issue of liquidity in small-cap funds and the rising frenzy in the segment have been a cause of concern for many months with Sebi engaging actively with mutual funds for a suitable solution. So, despite the fact that mutual funds have been sensitive to the liquidity requirement and seem comfortable with their portfolio allocation and cash levels, investors seem to be turning nervous about potential selling by small-cap fund managers in the coming days and months triggering a further fall in small-cap stock prices.

Why does the Stress Test matter and who should be worried? Here are the answers.

Why the Stress Test?

Sebi is concerned about a potential scenario wherein market sentiment turns and there are sudden redemptions and mutual funds are unable to honour redemption requests. Besides, in such situations, funds may decide to liquidate their most liquid positions and leave the portfolio with illiquid names for which there may be no-takers later, which will end up hurting the remaining investors in the scheme. Since mutual funds are open-end products, investors expect to get their money on tap whenever they need, hence Sebi’s concerns around liquidity.

What will this accomplish?

The test is only a directive to disclose the liquidity profile of a fund, so investors can clearly get a sense of how liquid their mutual funds assets are. It will also sensitise mutual fund managers to remain vigilant about liquidity and keep some money in cash and liquid assets to meet any sudden redemptions. This is something funds do anyway as part of their internal risk management.

Should fund unitholders care about this?

Liquidity is an important criteria in open-end funds – we all expect to get our money back when we want be it equity or debt.

But liquidity is not necessarily the most important criteria to choose a fund. That’s because an illiquid stock is not necessarily a bad stock; for example, a stock like Hawkins Cookers trades about 800 shares on a daily basis, but it boasts of a return on capital employed of nearly 40%. A stock like VST Industries trades about Rs 10,000 share per day but boasts of a return ratio of 38%, trades at P/e of 20x and is owned by a super investor like Radhakisan Damani. So liquidity of a portfolio is not a reflection of the quality of a stock or its ability to produce superior returns. So when it comes to choice of funds, it’s better to choose a fund that has a good track record of return over long periods (15 year or above), for it’s more likely the fund manager has seen multiple cycles to be able to navigate ups and downs.

Then, how should investors react to this data?

This should not form a basis for investors to buy or sell a fund. The liquidity Stress test is in fact a way of Sebi telling mutual funds that they can not shut redemption window if market conditions turn adverse.

This taken care of, investors need to remember that equities by their very nature are long-term products, because prices tend to be volatile. You need to take a five-year view while investing in an equity fund normally; some fund managers suggest small-caps may require a seven-year time horizon. Thus, if you invested in small-cap funds opportunistically in recent times, to cash in on this segment based on their stupendous returns near-term returns, it may be a good idea to pull back because this segment might take a breather for a while. Ironically, that may not be because any large-scale selling by mutual funds but because in stock markets, what is unsustainable finds a way to not sustain itself.

What exactly does that mean?

The small-cap category, despite the 7% correction in the past three weeks, is overheated. Most fund managers as well as the regulator have been saying there is froth building in this segment. While the overvaluation is very stark when you look at individual small-cap stocks, even aggregate numbers reflect the fact that they are pricier than frontline stocks. BSE Midcap index currently trades at 25.6x one-year forward P/e compared to its 10-year average of 24.61x while BSE Smallcap trades at 23.16x versus 21.55x. On the contrary, the Nifty 50 trades at a P/e of 20.39 versus 20.09. Eventually, markets gravitate towards more attractively priced pockets. This regulatory focus may act as a trigger for this pivot, among other factors at play in the market right now.

What are the other factors?

One big factor is the “stock operators” are turning cautious and backing-off from this segment because of heightening regulatory focus. The recent ED raid on Hari Shankar Tibrewal and 13 other associated entities with interest in stock markets has also resulted in price damage in stocks they are associated with. This is causing some stocks that were rising on narratives rather than strong fundamentals to wilt under pressure as the sentiment turns weak. In market, sentiment can turn quickly and matter more than action. It’s better to keep your ears to the ground. We do that for you. You keep track on Moneycontrol.

So, is it time to realign portfolios?

Fund managers themselves have been finding it hard to deploy cash in small-cap segment and calling out overvaluation in the segment. Since large-caps are now looking cheaper, they might shift focus to large-cap stocks and persuade investors to gravitate in that direction which will mean more buying could emerge in the large-cap segment. It’s good to thus go slow on small-caps stocks and stay invested only in high-quality stocks in that space. High quality means stocks with established track record of cash flows and high return ratios rather than stocks which are rising on narratives around future plans and projections.