The Association of Mutual Funds in India (AMFI) has asked its members to disclose stress test results every 15 days to comply with a recent mandate from capital markets regulator Sebi. The purpose of the stress test is to ascertain how soon fund managers can liquidate their portfolios, if investors were to rush for redemptions under adverse market conditions. The first set of disclosures is expected on March 15.
Also read: MF Stress Test: Why it matters and should investors be worried?
Sebi and mutual funds have deliberated on the issue of liquidity for months and finally arrived at a methodology. Here's how the stress test is designed:
Pro-rata liquidation of 25 percent/50 percent of portfolio, after removing the bottom 20 percent of portfolio based on scrip liquidity, considering 10 percent participation volume of three-month daily average traded volumes on both NSE and BSE with three-fold volumes. What’s the logic for these thresholds?
1. Liquidation of 25 percent/50 percent of portfolio: These are scenarios for which mutual funds’ liquidity is being tested. Meaning, under scenarios where 25 percent or 50 percent of investors came in for redemptions, how long will it take for a fund manager to liquidate his holdings and therefore number of days to honour those redemptions.
2. Removing bottom 20 percent of portfolio based on illiquidity: This is to allow room for a fund manager to hold on to illiquid stocks that he/she may think is high quality or would want to hold on to for a longer period for better returns. Normally, when redemption requests are placed, a fund manager won’t be cutting his most illiquid stocks first; those will be wound up last. Since the stress test is for scenarios of 25 percent or 50 percent redemptions, the most illiquid part of the portfolio need not be touched.
3. Three-month average trade volume: This is just a reasonable time period that reflects the prevailing market conditions and investor interest in individual stocks.
4. Three-fold volumes: Typically, when markets turn volatile, trading volumes spike. So, when markets go down, even if the stock price goes down, more shares get traded as people scramble to buy and sell. Past data bears out that under stress trading volumes are around three times the average prevailing volumes.
5. A 10 percent participation : This is under the assumption that a fund will only be able to sell down 10 percent of the traded volume through market sales in a day because everyone is scrambling to sell. This is just an assumption.
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