stress tests: Mutual Fund stress tests offer valuable insights but can’t be sole basis for investment decisions

Mutual funds have begun to disclose the results of stress tests for their small and mid-cap schemes following a recent directive from the Association of Mutual Funds in India (AMFI), in collaboration with the Securities and Exchange Board of India (SEBI).

These disclosures will be reported on a monthly basis and assess the liquidity of the portfolio’s stocks over the preceding three months.

They provide an estimate of the number of days necessary to liquidate 25% and 50% of the portfolio. However, in estimating this time to liquidation, 20% of the least liquid securities in the portfolio are not considered for the analysis. Thus, this method offers only an indicative profile of the portfolio’s liquidity compared to other similar portfolios.

The analysis also assumes a volume equivalent to 10% of the past 3 months’ average daily volume for liquidating the portfolio, which can vary significantly in actual market scenarios.

Furthermore, the disclosure encompasses the AUM share of the top 10 clients within the Mutual Fund Scheme. This aspect sheds light on the client concentration risk of investment. However, larger and established fund houses have lower client concentration risk compared to smaller fund houses, due to their larger AUM.

The larger fund size will need significantly more days to liquidate the assets, thus these no might not provide much insight to portfolio’s liquidity risk.There are some additional disclosures also available for mutual fund schemes that can provide more insights to investors including the standard deviation of the portfolio, Portfolio Beta and allocation based on market capitalization. Standard deviation and beta are statistical indicators used to understand the return profile of a portfolio. Standard deviation indicates the variability of returns from average returns, while beta measures the sensitivity of a portfolio’s returns compared to the market as a whole.

Both of these metrics have been widely used by investors to assess the risk and returns associated with investments.

While these disclosures offer supplementary insights to investors in mutual funds, it’s crucial to recognize that the information presented in stress test results is theoretical and may significantly diverge from market realities for the majority of funds. Stress tests assume significant withdrawals; however, during stressful scenarios, investors typically pause fresh investments in equity markets, while large-scale withdrawals are rarely observed.

Mutual funds also have the flexibility to allocate investments across stocks based on market capitalization, while they also keep a small portion in cash, thus further impacting liquidity during withdrawals, funds may adjust the portfolio allocation by liquidating the most liquid securities and end up using a lesser number of days to stabilize.

These disclosures also fail to accurately depict stress scenarios, as they do not consider the changes in the market value of the securities in such scenarios, and their impact on the value of the portfolio NAV. In the real-world environment, during times of crisis, security prices tend to fall sharply, while the liquidity of the security may also change. By considering only one aspect of the potential event, the stress test might oversimplify the impact of a crisis on the investment.

Therefore, stress test results should only be seen as providing additional insights to funds and should not be used alone for making investment decisions.

(The author of the article, Yashovardhan Khemka, is Senior Manager – Research & Analytics at Abans Holdings)