Stress test of mutual funds: Winners and losers in round 1

It would take an average of about 6 days for mid-cap funds to liquidate 50 percent of their portfolios and about 14 days on average for small-cap funds to liquidate 50 percent of their portfolios if equity markets were to collapse badly, investors rushed for redemptions, and liquidity in the markets dried up.

The sort of situation, which took place in 2008 after Lehman Brothers collapsed or even as COVID-19 first appeared on stage in March 2020. These are the broad results that have come out from the SEBI-mandated stress test results. The stress test was conducted across 56 small-cap and mid-cap schemes.

Even though, there is no COVID-19 or Lehman Brothers collapse scare, the stress test exercise was undertaken in the past fortnight as SEBI felt that there was froth building in the equity markets, particularly in the small- and mid-cap space. The market regulator felt that if markets were to crash and many investors rushed for redemptions, it was vital to know the liquidity situation of small- and mid-cap funds. That is why SEBI asked all fund houses to carry out stress tests; to determine how long would it take to liquidate 50 percent and 25 percent of their small- and mid-cap portfolios.

Additionally, SEBI also asked fund houses to crunch statistics to know how overvalued and volatile their schemes are. A stress test is an exercise to judge a fund’s preparedness in an adverse situation if we come to that. Here are the top six findings:

Small-cap deeper in water than mid-cap

Small-cap funds have a tighter liquidity situation than mid-cap funds. Simply put, it would take longer for small-cap funds to liquidate their portfolios than mid-cap funds. A scheme’s liquidity is important because it shows how quickly it can sell its stocks in the markets to generate cash to meet sudden redemptions if many investors end up at their doorstep to take back their money.

When markets fall badly, typically more investors withdraw their money. An illiquid MF scheme can stop redemptions, which can spread panic in the market, like Franklin Templeton’s six debt funds did in April 2021 when they shut down due to COVID-induced illiquidity.

To be sure, that was in the fixed-income market, but SEBI is taking no chances.

The average number of days to liquidate 50 percent of small-cap funds’ portfolios is 14, as opposed to six days for as much of mid-cap funds’ portfolios. Some fund houses have shown a vast difference between their small-cap and mid-cap funds. For instance, Axis Midcap Fund would take 12 days to liquidate 50 percent of its portfolio, Axis Small Cap Fund would take 28 days. Few other fund houses have more harmonious numbers between their schemes. Sundaram Midcap Fund would take 4 days to liquidate 50 percent of its portfolio, Sundaram Small Cap Fund would take 5 days.

Larger corpus, lower liquidity

Schemes with larger corpus will have a higher proportion of their portfolios in illiquid or low-liquidity stocks. Small-cap schemes with corpus of less than Rs 10,000 crore would take about 6 days on average to liquidate 50 percent of their portfolios. Schemes with corpus sizes between Rs 10,000-20,000 crore about 24 days on average. Schemes larger than Rs 20,000 crore would take about 43 days on average.The 10 largest small-cap funds

It’s the same with mid-cap funds. For schemes up to Rs 15,000 crore, it would take 3 days on average to sell 50 percent of their portfolios. For schemes above Rs 15,000 crore, it would take about 20 days.The 10 largest mid-cap funds

 

Unpleasant surprises

Most fund houses reported their stress test numbers on expected lines, but there were a few surprises.

Tata Small Cap Fund said it would take 35 days to liquidate 50 percent of its portfolio and 18 days to liquidate 25 percent of its portfolio. For a scheme with a corpus size of just Rs 6,289 crore, this number appears to be significantly high compared to some of its similar-sized peers. ICICI Prudential Small Cap Fund (Rs 7,415 crore) and Aditya Birla Sun Life Small Cap Fund (Rs 5,382 crore) would take just 10 days to liquidate 50 percent of their respective portfolios.

DSP Small Cap Fund said it would take 32 days to liquidate 50 percent of its portfolio and 16 days to liquidate 25 percent of its portfolio.

What’s common between the two is that neither has any investments in large-cap stocks for schemes of their size.

“DSP Mutual Fund believes in offering the products ‘true to the label.’ DSP Small cap scheme has zero exposure to the large caps as we want to offer pure small-cap exposure,” said a statement from DSP Asset Management after it made public its stress test results. The fund house says it takes comfort from the fact that its investor base is diversified.

“We shall be able to liquidate 25 percent of our entire portfolio in 9 (DSP Midcap Fund) or 16 days (DSP Small Cap Fund) respectively. This does not indicate the daily capability of the portfolio, which could be very different. We may increase cash in the scheme to further help improve our liquidity profile and will continue to be true to the label,” the fund house said.

Kotak Emerging Equity (KEE) reported the worst liquidity ratio, among all mid-cap fund results. It was that it would take 34 days to liquidate 50 percent of its portfolio. To be sure, KEE is the second largest mid-cap fund with assets worth Rs 39,738 crore.

Pleasant surprises

There have been some examples where fund houses appear to have managed their liquidity better. Quant MF is one such example.

Quant Small Cap- one of the 10 largest small-cap funds in the Indian MF industry with a size of Rs 17,233 crore, said that it would take 22 days to liquidate 50 percent of its portfolio. Among seven small-cap schemes that are there, over Rs 12,000 crore in the small-cap funds’ space, Quant Small Cap has reported the best liquidity. What's its secret?

Among other things, it has invested 28 percent in large-cap stocks; the highest allocation among most small-cap funds. “Our Predictive Analytics tools endorse that there are no classic signs of euphoria in Indian equities at this point in time. However, hype does get built in certain sectors or pockets and we mitigate these perceived risks by stock and sector rotation through our tools,” the fund house said in a statement after it made its stress test results public.

Edelweiss Mutual Fund reported good numbers among its size of schemes. Edelweiss Small Cap Fund (Rs 3,142 crore) would take just 3 days to liquidate 50 percent of its portfolio and 2 days to liquidate 25 percent of its portfolio. This, is despite no investments in large-cap stocks and just 3 percent in cash.

Also read: Where to invest Rs 10 lakh today? Swarup Mohanty, CEO, Mirae India suggests this strategy

Nippon India Growth Fund, worth Rs 24,481 crore in size, reported that it would take just 7 days to liquidate 50 percent of its portfolio. That’s impressive, given that Axis Midcap Fund with a similar size (Rs 25,248 crore) would take 12 days, and DSP Midcap Fund (Rs 16,302 crore) would take 17 days.

Is size a hindrance to small-cap funds?

If you go purely by the liquidity numbers in a stressed situation (which we are not in, at the moment), the picture isn’t pretty for some of India’s largest small-cap funds.

SBI Small Cap Fund, India’s third largest small-cap fund with a corpus size of Rs 25,534 crore, said that it would take 60 days to liquidate 50 percent of its portfolio. That’s two months. And it's the worst liquidity number in the category of small-cap funds. It would take a month (30 days) to liquidate just 25 percent of its portfolio. To take into account, this is only in the worst case scenario as pictured by SEBI in the formula it gave to mutual funds to do their stress tests.

HDFC Small Cap Fund (HSCF), India’s second-largest small-cap fund with a corpus size of Rs 28,599 crore, said it would take 42 days to liquidate half of its portfolio.

The surprise of the pack is the largest small-cap fund in the industry, Nippon India Small Cap Fund (NSCF). Nearly double the size at Rs 46.044 crore, NSCF will take 27 days (nearly half the time than HSCF) to liquidate 50 percent of its portfolio.

Portfolio overvaluation or undervaluation

The other interesting statistic that the stress test has revealed is how overvalued or undervalued your portfolio is. This shows if your fund is invested in stocks whose prices are perceived to have been run high or are still considered reasonable. The stress test seeks to compare your portfolio’s Price-Earnings (PE) ratio against its benchmark index.

Although Nippon India Small Cap reported good liquidity numbers, given its size and similar-sized peers, its PE ratio is 41.91 times, as opposed to 28.85 times its benchmark index. This is, by far, the most overvalued portfolio when compared to its benchmark index, among large-sized schemes. In chasing the more liquid stocks, Nippon India Small Cap Fund seems to be paying a higher price in terms of expensive stocks. Canara Robeco Small Cap Fund’s PE ratio is 47.9 times, as against its benchmark index’s PE of 28.9 times.

Should investors worry?

Liquidity is just one of the many parameters that determine a scheme’s worth. And it is not the only thing that determines its long-term performance. In the last month, SBI Small Cap Fund fell the least among the 10 largest small-cap funds, despite having the worst liquidity number.

SEBI has asked fund houses to publish their stress test numbers every 15 days. Investors should not panic. The regulator merely wants to throw light on small-cap and mid-cap funds to bring granular stats into the public domain so that investors understand what they’re getting into.

Moreover, the stress test imagines the worst-case scenario; where daily volumes are three times (to show more investors rushing to the markets to sell shares) and just 10 percent of that liquidity is available to mutual funds (to demonstrate illiquidity). The stress test results (number of days required to liquidate its portfolio) reflect that situation, not today’s. Besides, the quality of the companies also matters; the stress test is just one way of looking at a portfolio’s worth.

The stress test number, if looked at in isolation, is therefore misleading. Do not redeem from any of these schemes just based on their stress these numbers.

But it’s a good exercise to do when markets have gone up significantly because calamities don’t come knocking.