What SEBI Should Do After Mutual Fund Stress Tests
Results of mutual stress tests on small and mid-cap schemes are alarming: some of the large asset managers could take up to 60 days to return money to investors.
As asset management companies reveal the results of their respective stress tests on small and mid-cap schemes, it's time for the market regulator to take its next big step.
Funds have disclosed how long they would take to liquidate or redeem 25% and 50% of their small- and mid-cap portfolios, respectively. The results are alarming. Some of the large asset managers could take up to 60 days to return money to investors. And that's after factoring in cash and the highly liquid large caps they have.
What's next, then? The answer lies in looking at it from the perspective of investors.
Assume a small-cap fund with Rs 16,000 crore in assets, having over 14 lakh unique investors (not folios) and the top 10 investors holding just 1.4% of the assets.
If 10%, or 1.4 lakh, investors simultaneously seek redemption, how will that impact the scheme, its NAV and the fund house?
In the usual course of business, money is credited to investors' bank accounts on the third day since mutual funds follow T+2 settlement. This throws up a few issues.
An investor who moves early to redeem will encounter less disruption and lower losses in the portfolio. A case in point is Franklin Templeton, where early movers got their money faster and others had to wait for a long time to recover the full value of their debt instruments. The mutual fund was able to liquidate most of its portfolio and provide redemption to investors, but that NAV was nowhere close to the pre-crisis peak.
The second issue is pressure on NAVs as funds begin to liquidate their portfolios. While the stress test gives an idea of how long it will take for liquidation, things could actually be worse. NAVs would fall every day of the selloff.
The selloff will force the scheme fund manager or its trustees to impose redemption restrictions. While these may be aimed at safeguarding investor interest, there are no uniform guidelines to manage redemption in the event of stress in multiple funds.
Moreover, unlike the Corporate Debt Market Development Fund for bonds, there is no such backstop for equity funds.
One argument for that could be that while liquidity—a measure of buyers and sellers in the market—vanishes in the case of debt instruments, it rises for equity. An analysis of data for the past many years reveals that volumes on average rise nearly threefold under stress. But this liquidity is still too low to manage the redemption pressure, as is evident from the stress test results.
The value of equity also plunges at an unprecedented pace, even if the stock is liquid. Take Paytm. The stock lost nearly 40% of its value in two days. And it is just one stock. For mutual funds, the stress will be on the entire portfolio.
So the market regulator has to think about how to manage systemic redemption pressure for mutual funds facing stress.
Based on the results, SEBI will first have to identify schemes that pose high risk. For that, the regulator needs to set a threshold for liquidation and create parameters and guidelines to spot a stressful redemption event.
Clearly, SEBI has more work to do.
