Why the ‘Stress Test on Mid and Small Cap’ Funds Should Not Stress You Out

Given this context, on SEBI's directions, AMFI asked mutual fund houses to conduct stress tests on their mid and small-cap schemes and publish the results by 15th March 2024. The mutual fund houses have announced the much-awaited stress test results. So, what are the stress test results, and should you be stressed about them? Let us discuss.

Mid and Small-Cap Stress Test Results

AMFI has published the stress test report of mid and small-cap schemes of all AMCs on its website. One of the significant findings of the stress test report is the number of days it will take the AMC to liquidate 25% and 50% of each mid and small-cap scheme. Here are the findings of the stress test report for the top ten mid and small-cap schemes as per their assets under management (AUM).

Stress Test Report – Mid-Cap Funds

(Source: AMFI website)

Stress Test Report – Small-Cap Funds

Stress Test Report – Small-Cap Funds

(Source: AMFI website)

Note: The above data is for February 2024

The above result shows schemes with a higher AUM will usually take more time to liquidate their portfolio. While this is obvious, it will also depend on the overall market liquidity and individual stock liquidity at that time.

SBI Small Cap Fund has reported it will take 60 days to liquidate 50% of its portfolio. Should you be alarmed if you have an SIP currently in the SBI Small Cap Fund? If your financial goal is more than five years away, relax. You should continue with your SIP and watch the future stress test results. SBI Small Cap Fund will likely take steps to bring down the 60-day period in the future stress test results.

What Do These Stress Test Data Imply for Investors?

Do not react to these numbers in isolation and make emotional decisions about your investments. The number of days for liquidation in these funds is dependent on some key factors:

Fund size:

The larger the fund the longer it takes to liquidate stocks. For example, a fund with assets of 50,000 crores will take longer to liquidate compared to a fund with 10,000 crores of assets.

True to label:

A fund that has higher holdings in small and mid-cap stocks will take longer to liquidate compared to another fund that has lower exposure. For example, Fund A which is true to label and has 90% holdings in small and mid-cap funds will take longer to liquidate compared to Fund B which has 65% holdings in small and mid-cap funds. The key question here is the fact that you would like to invest in a fund that is true to the label.

Fund manager’s investment style:

Each fund manager has a theme or stock picks based on their internal research and beliefs. We should back the decisions of the professionals and allow time for their stock picks to play out. The stress test does not account for small stocks today which could be multi-baggers in the future.

Valuations & Growth:

Small and mid-cap stocks demand higher valuations because they are expected to grow far more significantly in the future compared to their larger, well-established, peers. This is the risk one is willing to bear for higher growth.

Number of stocks in the fund:

The stock holdings in funds vary. Higher concentration funds take a longer time to liquidate but also showcase the fund manager’s strong belief in his stock picks.

For an investor understanding the above two points is critical in decision making related to the ‘stress test’.

Your decision to invest or not to invest in the small and mid-cap space should be dependent on:

Having the right expectations:

Small and mid-cap investments carry higher risk, have lower liquidity and are more volatile. This higher risk also rewards higher returns in the long run. Market returns are never linear and usually a year with high returns can be followed by a year with low/negative returns.

Never invest for the short term based on past performance:

If you are solely basing your investment decisions on the past 12 months’ returns, it can lead to a terrible investing experience. Do not chase returns while investing.

Risk and reward go hand in hand:

A 3-4 % higher return over 10 years makes a substantial difference in your final corpus. The difference between a 12 % and a 16% difference over 10+ years can be the difference between meeting your goal comfortably or not.

Invest with purpose:

When you invest with clear objectives, it reflects in your decision-making. The information overload today can force you to have knee-jerk emotional decisions which can be detrimental towards your long-term objectives. Having a clear financial plan linked to goals helps you invest with purpose.

What After the Stress Tests?

AMFI, on SEBI’s directions, asked the AMCs to conduct stress tests to see their preparedness to handle large-scale redemptions if they were to happen.

AMFI has asked the AMCs to conduct the stress test and disclose the results every 15 days. Now that the test results are out in front of everyone, AMCs, whose numbers are of the higher side, will likely take steps to improve (reduce the number of days) in the forthcoming results. Some of the steps that the fund managers of mid and small-cap schemes may take include the following:

1. Reducing the holdings of illiquid stocks,
2.  Increasing the holdings of large-cap stocks,
3. Increasing the cash levels,
4. Putting more restrictions on fresh investments by stopping or limiting the lumpsum investments and limiting the SIP investments, etc.

AMCs may take any of the above steps, any combination of these, or all of the above. All these measures will reduce the number of days it will take the AMCs to liquidate their portfolio in the case of mass redemptions. These are investor-friendly measures. Hence, as an investor, you need not stress about the stress results.

Over a period of time, what if your AMC continues to report a higher number of days to liquidate the portfolio, and your financial goal is less than three years away? In that case, you may discuss with your investment expert. After discussing, if required, you may switch to a similar scheme of another AMC with better stress results or shift money to a balanced or debt fund as your financial goal is nearing. However, before switching, consider your investment time horizon, exit charges, capital gain implications, etc.

Small and Mid-Caps Carry Higher Risks

As an investor, you need to understand investments in equity mutual funds carry high risks. The risk in mid and small-caps is higher than in large-caps. Also, in the short-term, mid and small-cap stocks tend to be more volatile compared to large-cap stocks.

However, you also need to understand that in the long run, mid and small-caps have the potential to give higher returns. Also, the investment risk in mid and small-cap stocks tends to decrease in the long run. The volatility gets evened out in the long run. Hence, when investing in mid and small-cap funds, take informed risks.

Be aware of the risks and volatility involved in the short term and take it in your stride. Invest through the systematic investment plan (SIP) route. With SIPs, when the market goes down, you accumulate more MF scheme units. When the downfall reverses and the markets start going up, the value of your accumulated units will rise, and you will benefit from it.

You should invest in mid and small-cap funds only for your long-term financial goals that are more than 5-7 years away. Some of these long-term financial goals include accumulating money for a kid’s higher education and marriage, own and spouse’s retirement fund, etc. Investing in mid and small-cap funds is appropriate for these goals where the investment time horizon is more than 5-7 years.

Always Make Goal-Based Investments

You should sit with an investment expert and chart your short, mid, and long-term financial goals. Make a goal plan for each of these goals. The plan involves taking into consideration:

1. The current value of the financial goal
2. The future value after considering the years to achieve the goal, inflation rate, etc.
3. The monthly SIP amount required to reach the targeted amount after considering the investment time horizon, expected rate of return, etc.
4. Implementation of the plan and regular review till the goal is achieved

If you follow a goal-based plan and focus on it, market events/fluctuations will not distract you. Don’t let the greed and fear emotions come in the way. When you are focused on your goals, you will be able to cut the information clutter and navigate the noise. 

In that context, while the current mutual fund stress test reports are important, don't let them hinder your goals. Don't make any emotional decisions based on these results that will derail your financial planning journey. Use them to foolproof your financial plan. In short, don't let the mutual fund stress test results stress you. Use them to take corrective action, if any, de-stress, rejuvenate, and enjoy your financial planning journey.