Mint Primer | Mid, small-cap fund tests: You shouldn’t stress

livemint.com:

₹1.06 trillion at the end of Jan 2022 to ₹2.49 trillion at the end of Feb 2024. For mid-cap funds, the AUM has risen from ₹1.58 trillion at the end of Jan 2022 to ₹2.95 trillion at the end of Feb 2024. Thus it has more than doubled for small cap funds and grown 86% for mid cap funds.

The small cap returns in the past year alone has been 46.73%. All this has raised concerns around the ability of funds to handle a deluge of money, especially in a space which tends to have less liquidity. According to an AMFI circular, asset management companies must rank stocks in descending order of liquidity.

They must assume volumes that are 3 times the ordinary trading volumes in a stock and assume that they are able to liquidate the stock up to 10% of this volume per day. The reasoning appears to be that volumes spike up during times of panic. Next, they must exclude the 20% most illiquid stocks.

Using data for the 21st most illiquid stock, they must estimate how long it will take to exit 25% and 50% respectively of the portfolio. Funds have to give the days to liquidation. There are some pointers which can make the results look rosy.

First is the exclusion of 20% most illiquid stocks—the stress test is not on 100% of the portfolio. Second is the assumption of 3x volumes during panic selling. Such a surge may not happen.

Third, the test tells you about the ability of the scheme to liquidate its portfolio—not how much the asset value can fall by. No. The issue of poor liquidity came up in 2020 when Franklin Templeton faced heavy redemptions on six of its debt funds and the company took a sudden decision to wind up the schemes.