Can your mid-cap and small-cap mutual funds handle stress?

economictimes.indiatimes.com:

investors continue to pile on to this runaway train. But the market watchdog Sebi is sniffing some potential for trouble brewing within this heated space. As per reports, it has called for extensive stress tests of all mid-cap and small-cap equity funds.

Essentially, the regulator wants to ascertain whether mid-cap and smallcap funds will be able to withstand sudden outflows in case of steep correction in stock prices, without incurring heavy impact cost.

Liquidity is critical in mid- and small-cap funds. It refers to how easily underlying shares can be bought or sold in the market without significant loss of value. Apart from a few top-tier names, most stocks in this segment do not enjoy healthy trading volumes on the exchanges at all times.

When conditions are good, these are awash with liquidity. But when the tide turns, liquidity can dry up very rapidly. A fund that houses large chunk of its portfolio in such stocks becomes vulnerable.

The fund performance starts to deteriorate. The actual realisable NAV (net asset value) becomes lower than its calculated NAV. If faced with large redemptions in this scenario, fund managers find it difficult to quickly liquidate a portion of the portfolio.

“In adverse conditions, several stocks from this space find no buyers, but many sellers. It creates panic among investors which can hurt funds badly,” observes Arun Kumar, Head – Research, FundsIndia.

The perception of dark clouds gathering on the horizon for mid and small caps is not unfounded. According to a DSP Mutual Fund report, there is an unsettling calm prevailing in this segment.