For someone investing in mutual funds, liquidity is a key factor. How long will it take a mutual fund to meet your redemption request? The Securities and Exchange Board of India (SEBI) has mandated an efficient way to find out: through mutual fund stress tests.
A small-cap mutual fund may take longer to honour your liquidation request compared to its large- and mid-cap counterparts, as shares of smaller companies may be more difficult to sell. Among large- and mid-cap, similarly, the former is likely to see quicker redemption.
The mutual fund stress test devised by the SEBI looks to assess the endurance of liquidity management in the scenario that 25 percent or 50 percent of investors ask for their money back, amid extreme market conditions. Join us as we explore the importance of stress testing, its methodologies, and the insights it offers into the resilience of mutual funds.
Additionally, the SEBI and various fund houses have engaged in lengthy discussions regarding liquidity, culminating in the development of a stress test methodology.
Stress tests typically involve subjecting the entity to a series of hypothetical scenarios that represent extreme market conditions, such as sharp declines in asset prices, sudden changes in interest rates, or economic downturns. By analysing how the entity responds to these stress scenarios, analysts and investors can gauge its ability to withstand adverse conditions and identify potential vulnerabilities and risks.
In the case of mutual funds, stress tests help investors understand how the fund"s holdings and investment strategy might perform during periods of market turmoil or volatility. This information is valuable for investors looking to assess the risk profile of a mutual fund and make informed decisions about their investment allocations.
However, note that just considering the stress test results is not enough for any redemption decisions you are considering. There are several other factors that need to be taken into account, namely performance, standard deviation, and tax implications.
Liquidation of 25 percent and 50 percent of the portfolio: The stress test involves a pro-rata liquidation of either 25 percent or 50 percent of the portfolio. This aims to assess the amount of time a fund manager requires to liquidate holdings and answer redemption demands in the case that a significant number of investors demand it.
Removing the bottom 20 percent: The mutual fund stress test does not involve cutting the more illiquid part of the portfolio a fund can remove the bottom 20 percent of the portfolio based on the assets’ liquidity. Thus, fund managers can retain any stocks they think need to be held longer for better gains.
First Published: Apr 16, 2024, 10:25
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