Wealth edition 25-Mar-2024 to 31-march-2024

Frothy valuations, illiquid portfolios and concentrated investor mix. These were among the biggest concerns of market regulator, Sebi, when it ordered the mid- and small-cap funds to undergo comprehensive stress tests recently. This exercise—now slated to be a monthly affair— is aimed at unearthing the latent risk in a mid- or small-cap fund when the markets are under stress. The results came out last fortnight, sparking swift judgements on social media.

Based on initial test outcomes, some funds have seemingly come out with flying colours. These funds will be able to offload a quarter or even half of their holdings within a matter of 2-3 days, if the need arises. On the other hand, there are a few surprises. For instance, the SBI Small Cap Fund may take up to 60 days to offload half of its portfolio when under stress (see graphic). These outliers are being perceived as risky. Are investors drawing the right conclusions? Are some funds illprepared for a doomsday scenario? Should you buy or exit a fund based on these test results? We attempt to filter out the noise around the much-hyped stress tests to find out whether investors need to be worried.

Fund size matters
When small-cap funds were relatively smaller in size, liquidity wasn’t a big concern. But with the category now commanding a hefty AUM of nearly Rs.2.5 trillion, the impact of heightened market volatility on portfolio liquidity cannot be ignored.

According to the stress test data compiled by AMFI, the estimated time taken to liquidate 25% of small-cap portfolios varies from a quarter of a day to as long as 30 days. When offloading 50% of the portfolio, the figure extends up to 60 days. This suggests a long wait for redeeming investors and is problematic for a vehicle that promises T+2 settlement. Experts say that funds taking longer to liquidate is not necessarily a red flag. “The smaller the AUM of a fund, the shorter time it needs to liquidate. A largesized small-cap equity scheme usually does not take a very high small-cap allocation, but there can be exceptions,” says Amit Kumar Gupta, Founder, Fintrekk Capital.

So, don’t be taken aback if the Rs.46,000 crore Nippon India Small Cap takes 27 days to sell 50% of its portfolio, when the Rs.1,436 crore PGIM India Small Cap is estimated to take just a day to do the same. In fact, smallcap funds with at least Rs.10,000 crore AUM may take 30 days, on an average, to sell 50% of the portfolio. Large funds have longer tails (95 stocks on an average), which means they require more time to sell these holdings.

In the mid-cap space, the 10 biggest funds could take 14 days to liquidate 50% of their portfolios, compared to less than three days for others. So, the biggest scheme, the Rs.60,000 crore HDFC Mid-Cap Opportunities, taking 23 days should not be a cause for alarm.

At the same time, if a fund with the same or lower AUM requires more time to sell, investors need to find out why. A case in point is Rs.39,800 crore Kotak Emerging Equity, which could take 34 days to offload 50% of its portfolio. “All things remaining the same, if time taken to exit is materially longer, it could be a reflection of portfolio liquidity,” says Yoganand D., an investment planner at Ladco Crest Wealth.

Some mid- and small-cap funds rank low on liquidity
Funds with larger assets under management are estimated to take longer to liquidate their holdings.



Flexibility in fund mandate
A mid- or small-cap fund has to invest a minimum of 65% of its assets in mid- and small-cap stocks. It retains the flexibility to invest the balance 35% in stocks of a different market-cap segment. Typically, fund managers use this leeway to optimise portfolio performance.

In some small-cap funds, a big chunk of this 35% gets parked in mid caps and even in large caps, apart from cash holdings. Others prefer to offer a true-to-label experience, limiting exposure to other marketcap segments. A fund’s liquidity profile should be judged in correlation with its market-cap distribution.

For instance, the HDFC Small Cap and SBI Small Cap may take more time (42 days and 60 days, respectively) to offload half of their stocks. This could be attributed to their having over 10 percentage points higher small-cap exposure, versus bigger and like-sized peers. From a return perspective, higher small-cap exposure could work well during rallies, but will act as a drag during downturns.

“There is no way to know when an adverse event will occur and, hence, one cannot choose a small-cap scheme based on its 35% allocation,” says Amol Joshi, Founder, PlanRupee Investment Services. For investors, the best strategy is to keep their small-cap allocation within reasonable limits and not chase past returns.

Small-sized funds boast higher liquidity

These schemes are estimated to liquidate their portfolios more quickly due to the smaller asset base.



Bigger small-cap funds appear more liquid when they have substantial largecap allocation. For instance, the Nippon (27 days) and Quant (22 days) offerings fare better than many others largely due to 13% and 28% large-cap allocation, respectively. This is evident in their mid-cap offerings too. Often perceived as high-risk strategies due to their outsized returns, Quant Mutual Fund’s schemes have astonished many naysayers, thanks to big large-cap allocations currently.

Some larger funds also have good liquidity due to high allocation to cash and large-caps stocks
These liquid assets cushion the redemption pressure on the fund when markets are under stress.



Some small-cap funds seem to boast adequate liquidity even without any largecap allocation. These include offerings from UTI Mutual Fund, Edelweiss Mutual Fund, PGIM India Mutual Fund and Union Mutual Fund. The same journey can lead to different paths. Zero large-cap exposure may not work out that well for some relatively smaller funds, such as the Rs.6,200 crore Tata Small Cap, which would need 35 days to offload 50% of its portfolio.

Investor concentration
Another data point investors need to look out for is the level of investor concentration in a fund. Unlike liquidity ‘scenarios’, concentration is a real number. If your small- or mid-cap fund has a relatively tiny group of investors holding a large proportion of assets, it is a cause for concern. Concentrated investor mix can make a fund more susceptible to lumpy redemptions. Even this comes with caveats.

On paper, the top 10 investors hold 11-22% of assets in Bandhan Small Cap, Motilal Oswal Small Cap, Mahindra Manulife Small Cap and ITI Small Cap (Rs.1,500-4,400 crore AUM range). It is not uncommon for smaller schemes to have higher investor concentration, as they tend to have a smaller investor base. Larger funds, especially those with a longer history, are typically spread across more investors, reducing the risks of large redemptions happening at one go. For instance, the SBI Small Cap, which might seem less liquid due to the longer period required to offload its portfolio, has a top 10 investor concentration of just 0.6%. In the mid-cap arena, offerings from Motilal Oswal Mutual Fund (23%) and JM Mutual Fund (15%) exhibited higher top 10 investor concentration.

If a fund’s AUM is spread across a larger number of folios, chances of 25% or 50% of portfolio coming up for redemption at the same time would also be lower. “If the top 10 or 100 investors decide to exit the SBI Small Cap Fund, it won’t warrant significant liquidation exercise. In the case of Motilal Oswal Midcap Fund, the fund manager may have to trim exposures to service the redemption,” says Nirav Karkera, Head of Research, Fisdom.

To be sure, a granular study of investor mix is required in some funds with greater ‘skin in the game’ from sponsors and fund managers holding significant stakes. The sensitivity to sudden and large redemptions in a fund will largely be to the degree of voluntary contributions from such stakeholders.

No need to get stressed
Stress testing of small-cap and mid-cap funds is a good exercise in alerting investors about the potential liquidity risks in these segments, but it remains purely a hypothetical exercise.

Firstly, drying up of liquidity is more common in bond markets than in equity markets. It was evident in 2020, when a severe liquidity crunch forced the winding up of Franklin Templeton Mutual Fund’s six debt schemes. Equity funds have so far never faced any crisis of this magnitude. Equity funds primarily attract retail participants, with individual investors holding 56% of equity fund AUM. Past trends indicate that during market downturns, retail investors tend to halt new investments, but refrain from immediately redeeming from equity funds due to their aversion to booking losses. “The depth of the Indian capital markets has grown significantly over the past decade and, hence, the possibility of a self-perpetuating vicious cycle during market crashes remains slim,” suggests Varun Fatehpuria, Founder, Daulat Wealth Management.

Concentrated investor base is risky
These funds will face lumpy redemptions if big investors exit together.



Second, the way it is designed, stress test may not give an accurate picture of liquidity (see box). The prescribed framework for calculating liquidity is based on assumptions that could be far from reality. Funds that are currently high on liquidity may actually take far longer to liquidate holdings. Similarly, funds with lower liquidity reading may do far better or worse than what the model predicts. As such, investors need to take these figures with a generous pinch of salt. In any grading or scoring system, reducing complex attributes to a single figure is potentially misleading.

The outcome of a simulated stress test cannot be the sole reason to buy or exit a fund. It is akin to buying or selling an actual car after playing it in a virtual video game. The test conditions are very low probability events. “How often does it happen that 25% or 50% of the corpus of an equity fund with very granular liabilities comes up for redemption simultaneously?” asks Aashish P. Somaiyaa, CEO, WhiteOak Capital Asset Management.

Even if the event were to materialise, mutual funds would be able to liquidate and meet redemptions within a reasonable time frame. Regulations even permit funds to borrow up to 20% of their assets to address short-term liquidity requirements, which offers a substantial buffer.

Some funds have pricey portfolios
These schemes hold stocks of companies that boast superior quality and growth, which, in turn, command high premiums.



Why the stress test falls short
At the outset, the Sebi prescribed framework simulates how long it will take funds to exit 25% and 50% of the portfolio. Experts point out this is a highly unlikely scenario. Even during periods of stress, redemptions are typically far lower. Next, the available liquidity at any point is calculated on the basis of trading volumes in the preceding three months. Healthy market conditions during this time frame will naturally make for a rosy assessment of available volumes. These volumes could disappear when the funds actually need to liquidate holdings. Further, volumes under stress are assumed to be 3x those of the preceding three months. The premise is, trading volumes spike during market panic. Again, this presumption may be incorrect. Some stocks may, in fact, see drying up of volumes when conditions turn sour.

The calculation also provides that 10% of a security’s available volume will be at a single fund’s disposal on any given day. However, under stress, if several other equity funds, along with retail and institutional investors holding the same stock, seek an exit, this volume will simply not materialise. Finally, the framework provides that the fund will retain its most illiquid stocks aggregating to 20% of the portfolio, while liquidating the remaining portfolio. The number of days required for the fund to liquidate its portfolio is derived from the figure pertaining to the least liquid stock from the remaining 80% of the portfolio. This, again, is not realistic. To meet sudden redemptions, a fund manager will not sell the fund’s illiquid shares first. He is likely to first dip into the cash reserves and then sell highly liquid large-caps or mid-caps to keep the impact cost low. In this scenario, it will take much lesser time for a fund to liquidate holdings.

Besides, the stress test results only reveal how quickly a fund can liquidate its portfolio; they do not indicate how this selling will impact the fund’s NAV (net asset value). During times of stress, the actual realisable fund NAV can be lower than its calculated NAV. This critical piece of puzzle is missing in the stress test results.

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