Mutual fund stress test provides clarity for investors

Last week saw mutual funds in India publish the results of what is referred to as the ‘results of the stress test and liquidity analysis of mid and small cap equity schemes’. Image: Shutterstock
 
If you are over the age of 50, as I am, then the doctors suggest an annual health check-up for you. Some suggest that one should go through a comprehensive health check-up even at an earlier age.

After all, it’s a simple process requiring only a small investment of time that could be invaluable in flagging potential health risks. An integral part of the check-up is a ‘stress test’. They wire you up to an ECG machine and make you walk on a treadmill, slowly at first and then more swiftly, often on an incline. It is a simulation of stress in what would otherwise be a simple fitness test on a treadmill.

Last week saw mutual funds in India publish the results of what is referred to as the ‘results of the stress test and liquidity analysis of mid and small cap equity schemes’. The disclosure covers parameters related to volatility, valuation and portfolio turnover. Ahead of the release of this disclosure, there was nervousness among market participants about the need and concerns surrounding what the data might reveal. Not unlike the butterflies in my stomach when I nervously glance at the doctor monitoring the stress test. It takes a smile from the doctor or a thumbs-up signal to put my nervousness to rest.

The disclosure published by mutual funds, including the stress test, is based on data that is in the public domain. This data includes valuation of the benchmark, valuation of the portfolio, standard deviation of portfolio and benchmark, beta and portfolio turnover ratio. These are all published by the funds themselves and are also available through several third-party platforms and publications.

For the stress test, the calculation is based on the number of days it would take to sell the portfolio on a pro-rata basis in case of large-scale redemptions (assumed at 25 percent and 50 percent of the assets of the scheme). For this, the 20 percent least liquid securities in the portfolio are ignored and the calculation assumes the remaining holdings will be sold on a pro-rata basis.

Several other considerations determine the choice of securities to sell as well as cash in the portfolio. The stress test is just like the inclined treadmill set at a high speed, assuming a more dramatic redemption rate. This is unlike the historical data but that is the purpose of a stress test. A likely mitigant against simultaneous large-scale redemption is the wide investor base in the schemes. For example, the UTI Mid Cap Fund has Rs 10,047 crore AUM over 5.26 lakh folios and the UTI Small Cap Fund has Rs 3,653 crore AUM across over 2.95 lakh folios as of February 2024.

An additional disclosure that is being provided for the first time by the fund houses is the concentration risk of the scheme from the perspective of the unit holders, ie how much of the scheme is held by the top 10 investors in the scheme. Therefore, you can now assess both the asset and liability profile of the scheme.

It is a big win for investors as they now have access to a single source for a comprehensive disclosure template that contains a standardised set of metrics from all the fund houses. This makes collation and monitoring of portfolio characteristics easier for investors, enabling them to make informed decisions.

Also read: Liquidity risks or valuations: What's boiling in mid and smallcap stocks?

Another point to ponder is whether there has been a disproportionate rush by investors into the mid and smallcap space. The Nifty Midcap 150 TRI has gone up 4.5 times from March 2015 to January 2024. During the same period, the daily average trading volume (three-month average) of the index increased from Rs 4,170 crore to Rs 23,749 crore per day, a rise of 5.7 times. During this period, the category AUM (midcap schemes) went up even faster, from Rs 33,823 crore to Rs 2,90,297 crore, a rise of 8.6 times!

The numbers for the smallcap space reflect the more pronounced surge into smallcap stocks in recent times. From a base in March 2017, the Nifty Smallcap 250 index is up 2.9 times, while the category AUM has gone up 12.6 times to Rs 2,47,549 crore, as of January 2024. Daily average turnover has gone up 5.3 times to Rs 18,926 crore per day. As an aside, the daily average turnover of the Nifty Smallcap 250 index is higher than the total AUM of the smallcap category in March 2017!

The rise of AUM has been faster than the increase in market value, but this also reflects rising participation by the investors, which is a desirable policy goal. As the Indian capital markets grow, there is scope for further democratisation of the investor base driven by increased savings and financial education. As a result, Mutual Funds alongside other market participants, including pension funds, provident funds and insurance companies, would own a rising share of the market.

We should look at the US data as a potential benchmark for India in the future. According to research published by the Investment Company Institute (ICI), 54.4 percent of households in the US owned mutual fund schemes or exchange traded funds (ETFs) in 2023. The US Mutual Funds (including ETFs) own 28 percent of the US market, while the Indian mutual funds own 9 percent of the overall market capitalisation. As the Indian equity market grows and witnesses rising participation, we need to revisit some of our framework and governance structures.

The categorisation of companies as large, mid and small was introduced by the Securities and Exchange Board of India (Sebi) in 2017. This method limits the universe of companies classified as large and midcap to a fixed total of 250 companies permanently. There have been 215 listings in India from 2018 to 2023 and these companies have a market capitalisation of $459 billion at current prices. We need a flexible method of market capitalisation categorisation that expands alongside the increase in listings.

Given the likely growth trajectory in India over the next decade, there are two more agenda points to consider: We need to encourage listings by companies, and increase free float. The current norm of public float set at 25 percent may need to be set higher. A large, liquid and broad-based market keeps the market healthy, and a health check is a good practice.

The writer is CIO, UTI Asset Management Company Limited
(Disclaimer: The views expressed are author’s own views and not necessarily those of UTI AMC Limited)