What is a Stress Test in the Stock Market? And How Does It Affect Your Portfolio?

The market darlings of 2023, mid-cap and small-cap stocks are facing a long-awaited reality check in 2024.

Midcaps and smallcaps made a strong comeback in the previous year, outperforming largecaps by a wide margin. While the Nifty Midcap and Nifty Smallcap indices surged 40-50% in 2023, the benchmark Nifty rose about 19%.

Even in 2024, the benchmarks as well as the broader markets hit new peaks in the first week of the year. This was amid positive global cues, hopes of a rate cut, continued foreign investor inflows, and the Q3 earnings season.

After such a strong rally, a long-anticipated correction has arrived, with these once-hot stocks experiencing a reality check. The initial decline was steep, with the mid-cap and small-cap indices dropping 6% and 11% monthly, respectively.

However, a recent relief rally helped pare some losses, bringing them down to 3.4% and 7% as of 15 March. Interestingly, the pain isn't evenly distributed. While the broader indices reflect a correction, the sell-off is particularly brutal for individual small-cap and micro-cap stocks.

Amid discussions surrounding this correction in the stock market, a term that you would have come across these days in the headlines is a 'stress test.'

The recent steep decline in mid-cap and small-cap stocks has been attributed to stress tests on mutual funds.

What Exactly is a Stress Test?

In the context of mutual funds, a stress test is a test that reveals the time within which an investor can recover their investment in the event of a downturn in the equity market, especially when the mutual fund is faced with a surge in investor redemptions.

Specifically, the stress test shows the total time required to liquidate around 80% of the portfolio. The regulator allowed mutual funds to exclude the least liquid 20% of the portfolio.

The stress test was done by mutual funds to evaluate the liquidity of their mid-cap and small-cap portfolios. They calculated the time required to liquidate 50% and 25% of portfolios, on a pro-rata basis, excluding the bottom 20% of portfolios based on liquidity.

The test checks two things: selling speed and price impact. Selling speed checks how quickly can a fund manager sells small-cap stocks if many investors were to redeem their investments. The price impact checks whether selling these stocks would bring down their price significantly or not.

Stress tests typically involve subjecting the entity to a series of hypothetical scenarios that represent extreme market conditions, such as sharp declines in asset prices, sudden changes in interest rates, or economic downturns.

By analysing how the entity responds to these stress scenarios, analysts and investors can gauge its ability to withstand adverse conditions as well as identify potential vulnerabilities and risks.

In the case of mutual funds, stress tests help investors understand how the fund's holdings and investment strategy might perform during periods of market turmoil or volatility.

This information is valuable for investors looking to assess the risk profile of a mutual fund. It can assist them to make informed investment decisions.

Why is There a Need for a Stress Test?

The market regulator and the Association of Mutual Funds in India (AMFI) have been concerned about the large quantities of inflows of funds from investors into midcaps and smallcaps.

According to AMFI data in 2023, small-cap funds saw net inflows of Rs 410.4 billion (bn), and mid-cap funds saw net inflows of Rs 229.1 bn. On the other hand, large-cap funds witnessed a net outflow of Rs 29.7 bn.

With around Rs 640 bn being poured into mid-cap and small-cap funds, the regulators directed fund houses to run a stress test. This was mostly a liquidity analysis based on a specific methodology.

The stress test would evaluate how many days it would take for a fund to liquidate 25% and 50% of its portfolio.

After a directive from the regulator, AMFI instructed its members to reveal stress test findings every 15 days on their websites.

Stress Test Results

Mutual fund houses started declaring the stress test results on 14 March on their respective websites. The first deadline to declare the stress test result was 15 March.

	Days to liquidate
	Small-cap Funds		Mid-cap Funds
	25%	50%	25%	50%
Aditya Birla Mutual Fund	5 days	*	2 days
Axis Mutual Fund	*	28 days	*	*
Canera Robeco Mutual Fund	6.8 days	13.5 days	*	*
DSP Mutual Fund	16 days	32 days	*	*
Edelweiss Mutual Fund	2 days	3 days	1 days	2 days
Franklin India Mutual Fund	6 days	12 days	*	*
HDFC Mutual Fund	*	42 days	12 days	23 days
Kotak Mutual Fund	17 days	33 days	17 days	34 days
Motilal Oswal	2 days	3 days	5 days	10 days
Nippon India Mutual Fund	13 days	27 days	4 days	7 days
Quant Mutual Fund	11 days	22 days	3 days	6 days
SBI Mutual Fund	25 days	60 days	*	*
Tata AMC	18 days	35 days	2 days	3 days
UTI Mutual fund	2.1 days	4.3 days	2.1 days	4.2 days

Data Source: Media Reports

Among the mid-cap funds, HDFC Midcap Opportunities Fund is the largest with over Rs 600 bn in assets. The fund would take 12 days to liquidate 25% of the portfolio, and 23 days to liquidate 50% of the portfolio. This is one of the most illiquid funds in its category after Kotak Emerging Equity Fund.

HDFC Midcap Opportunities Fund invests 80% of the money in mid-cap and small-cap stocks, 13% in large-cap stocks, and maintains 7% cash.

In terms of valuation, the HDFC Midcap Opportunities Fund portfolio shows a 12-month trailing price-to-earnings (PE) ratio of 23 compared with the benchmark PE of 27.

Across all mid-cap funds, schemes may take less than a day to 34 days to liquidate 50% of the portfolio. Of the 26 midcap funds, only six will take 10 or more days to liquidate 50% of the portfolio.

Among small-cap funds, SBI Smallcap Fund has the most illiquid portfolio, as it would take 60 days to sell off 50% of the equities it is holding in the portfolio. It would take 30 days to sell off 25% of the portfolio. SBI SmallCap Fund has an asset size of Rs 255 bn, one of the larger funds in the category.

The second most illiquid fund is HDFC SmallCap Fund, with Rs 286 bn assets under management. The fund would take 42 days to liquidate 50% of its portfolio and 21 days to liquidate 25% of its portfolio.

Across the category, smallcap funds take anywhere from one day to 60 days to liquidate 50% of the stocks in the portfolio.

Most smallcap funds hold from 65-95% of the portfolio in smallcap equities.

What do the MFs say?

The market regulator's stress test results highlight the potential liquidity risk associated with smallcap funds.

While the overall results show a longer liquidation time for the top small-cap funds, individual performances varied. Some funds might be more efficient than others in selling their holdings.

Also, funds with a larger corpus have lower liquidity. While most mutual funds followed the above rule, there were a few exceptions. For example, Tata Small Cap Fund said that it would take 35 days to liquidate 50% of its portfolio, which is significantly higher than peers with similar AUM.

Tata and DSP manage their small-cap funds with a true-to-the-label strategy as they invest nearly 90% of the corpus in small-cap stocks vis-a-vis 65-80% allocation in the case of other larger schemes.

All the schemes, having less than Rs 50 bn AUM have said that 50% of the assets can be sold within five days.

Conclusion

The stress tests provide investors with crucial insights into the liquidity of their mutual fund investments. This can foster confidence and ensure fund managers are prepared to handle sudden redemption pressures.

Overall, these results underscore the importance of stress testing to provide investors with clarity on mutual fund liquidity. It also highlights the necessity for mutual fund managers to maintain liquidity awareness and readiness to meet sudden redemption demands effectively.

This transparency should reassure investors and mitigate the potential for panic selling that may have been anticipated earlier.

Although concerns about valuations persist, the regular availability of stress test results enables investors to better understand the market dynamics.

However, to be on the safer side, don't put all your eggs in one basket. Invest in a mix of asset classes, including large-cap funds, debt instruments, and gold, to balance risk and potential returns.

One should look for funds with a strong track record, clear investment strategies, and transparency regarding liquidity.

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