Things You Should Know About Mutual Fund Stress Test | SEBI Ordered Small and Midcap Mutual Funds to Perform Stress Test

Association of Mutual Funds in India (AMFI) and the Securities and Exchange Board of India (SEBI) released a circular that requires asset management companies (AMCs) to conduct a stress test based on previous month data and disclose results for small and mid-cap schemes by March 15 each year. The aim of this initiative is to give investors a better understanding of the risk profiles of these schemes and improve transparency.

However, most of the influencers in YouTube associated the recent fall in share market is due to the impact of executing the stress test. Let us clarify what is mean by stress test in Mutual fund and how it is carried out?

How mutual funds conduct stress test?

Mutual funds conduct stress tests to assess the liquidity of their portfolios, particularly those holdings in small-cap and mid-cap stocks. This involves simulating a scenario where there's a sudden surge in redemption requests from investors. The stress test measures the time it takes the fund house to sell these assets and meet redemption requests without fire-selling other holdings at potentially lower prices.

You may ask what is mean by fire-selling?

A fire sale refers to the selling of assets at significantly discounted prices, often well below their actual value. The term originated from the practice of retailers needing to quickly get rid of inventory that was damaged by fire. In the context of mutual funds, fire selling would involve selling securities in a short period to meet redemption requests. This can be risky because it may force the fund to sell assets at lower prices than they're worth.

Do mutual funds perform stress tests by actually selling the stocks?

The answer is No, mutual funds don't conduct stress tests by actually selling their holdings.  Stress tests are simulated exercises that evaluate how the portfolio would perform under specific hypothetical conditions.  This helps fund managers assess potential risks and develop strategies to mitigate them.

What are the strategies mutual funds may implement to mitigate the risk identified in stress test results?

Mutual funds can employ various strategies to mitigate liquidity risk:

Maintain a buffer of highly liquid assets:  This includes cash and equivalents, government bonds, and other assets that can be easily converted to cash without significant price fluctuations.

Invest in diversified assets:  A diversified portfolio reduces the fund's reliance on selling less liquid assets to meet redemptions.

Invest in high-quality, liquid securities:  Prioritizing assets with a history of being easily tradable reduces the risk of fire sales during stressed market conditions.

Impose redemption fees on short-term investors:  This can discourage investors from redeeming their shares frequently, especially during periods of market volatility.

Use redemption gates:  In extreme circumstances, some funds may implement temporary restrictions on redemptions to give the fund manager time to sell assets in an orderly manner.

Conclusion

Hope you understand now the recent fall in stock market is not due to the outcome of stress test result done by mutual funds as per SEBI order.

Disclaimer: These are only suggestive technical rules that have been found to work well over time in the market. These are not any trading or investing recommendations. We suggest you to take advice from certified experts for trading and investing. Neither PickMyStox nor any of its associates are responsible for any trading or investing loss.