Mutual fund stress test: Methodology and test results for small and mid cap funds

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.

Calculation methodology for mutual fund stress test

The Sebi, with the goal to test how quickly a mutual fund can meet redemption requests, has come up with a methodology for the mutual fund stress test. Below, we have simplified the test structure for you:

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.  

Stress test results for small cap funds

Here are some of the mutual fund stress test results for February and March 2024, and what they mean for investors:

*Pro-rata liquidation after removing bottom 20% of portfolio based on scrip liquidity (considering 10% PV with 3x volumes)

Stress test results for mid cap funds

Here is the Stress Test & Liquidity analysis data of mid cap funds for March and February 2024.

*Pro-rata liquidation after removing bottom 20% of portfolio based on scrip liquidity (considering 10% PV with 3x volumes)

Through stress tests, investors gain clarity on the liquidity of their mutual fund assets. It also encourages mutual fund managers to maintain liquidity awareness and readiness for sudden redemptions.

Overall, these results underscore the importance of stress testing in providing investors with clarity on mutual fund liquidity. It also highlights the necessity for mutual fund managers to maintain liquidity awareness and readiness to meet sudden redemption demands effectively.