What is the importance of liquidity stress testing for investors in mid-cap and small-cap mutual funds? Explainer

Mutual fund companies are now required to disclose the liquidity levels of small and mid-cap stocks every month by conducting so-called “stress tests.”

These instructions are provided by the Association of Mutual Funds of India (AMFI) Following notable frothiness in small and mid-cap stocks. Therefore, prospective investors should be alerted through these disclosures before choosing mid-cap and small-cap mutual funds to invest their hard-earned money.

This is of great significance as several fund houses have restricted bulk investments in small-cap schemes after witnessing large inflows into their schemes. In particular, small-cap schemes have attracted too many retail investors as they have delivered high annualized returns of up to 70% over the past few years.

Last year, Tata Mutual Fund and Japan Mutual Fund restricted inflows into small-cap schemes, and earlier this month, Kotak Mutual Fund introduced similar restrictions.

All mutual fund companies are supposed to publish their stress test results monthly on their official portal and AMFI website. This report was first launched on March 15, 2024.

According to a recent directive from the Association of Mutual Funds of India (AMFI), asset management companies (AMCs) are required to publish the stress test results of small and mid-cap schemes by the 15th of the next month as per the aforesaid provisions. I am. Monthly data.

Also Read: Liquidity Stress Test Results for Top 10 Mid-Cap Mutual Funds

Small and medium cap fund

According to Sebi’s classification of mutual fund schemes, a mid-cap mutual fund refers to a scheme that invests at least 65 per cent of its assets in mid-cap stocks, while the remaining 35 per cent is invested in other categories, i.e. small and large caps. You can invest. .

Similarly, a small-cap mutual fund refers to a scheme that invests at least 65% of its assets in small-cap stocks.

Significance of stress test

The idea behind stress testing is to highlight the illiquidity of the stocks in which a mutual fund scheme is investing. This is intended to reveal the level of free float in a fund scheme’s portfolio.

Free float refers to stocks that can be traded freely on stock exchanges. Stocks owned by retail investors and not subject to any lock-in are typically free-floating.

According to data released by the mutual fund company, HDFC Midcap Fund takes as long as 23 days to redeem 50% of its portfolio. The corresponding period for Axis, Kotak and SBI midcap schemes is 12 days, 34 days and 24 days respectively.

(Source: AMFI)

The risk appears to be even higher when it comes to small-cap funds. While some schemes such as Quantum Small Cap Fund take just one day to redeem 50 per cent of the portfolio, there are also riskier schemes such as SBI Small Cap Scheme, which take just one day to redeem half of the portfolio. takes as long as 2 months. .

(Source: AMFI)

Similarly, HDFC Small Cap fund takes 42 days to redeem 50% of its portfolio, Tata Small Cap takes 35 days, Axis Small Cap takes 28 days and Kotak Small Cap takes 33 days.