The Securities and Exchange Board of India (SEBI) has proposed a new mandate requiring asset management companies to disclose the results of stress tests for all mutual fund schemes, excluding close-ended and interval schemes.
In a consultation paper released on Wednesday, SEBI outlined that stress testing must be conducted at least monthly to help investors make informed decisions.
Currently, the disclosure of stress test results for small-cap and mid-cap mutual fund schemes is mandatory. These results must be published on the websites of the Association of Mutual Funds in India (AMFI) and the respective Asset Management Companies (AMCs).
“This would also align with the recommendations of the Financial Stability Board (FSB) in the report dated December 20, 2023, on Revised Policy Recommendations to Address Structural Vulnerabilities from Liquidity Mismatch in Open-Ended Funds’,” SEBI says in its consultation paper.
The FSB's sixth and ninth recommendations suggest that authorities consider system-wide stress testing to assess the impact of collective selling on market resilience. Additionally, it emphasises the need for stress testing at the individual fund level to manage liquidity risks and support financial stability.
A mutual fund stress test evaluates how well a fund manager can liquidate a portfolio during sudden investor redemptions under unfavourable market conditions. It helps investors assess how a fund's assets and strategy may perform in adverse conditions, revealing potential risks and vulnerabilities. The test, required by the AMFI every 15 days, subjects the fund to hypothetical extreme market scenarios, such as sharp declines in asset prices or sudden interest rate changes.
The test measures the time it takes to liquidate 25% and 50% of the portfolio, based on recent trading volumes, to assess liquidity. The test also evaluates the price impact of selling stocks, and whether it significantly lowers their prices.
However, the question is why SEBI proposed this change in the "skin in the game" consultation paper.
“Notwithstanding the relaxation from the requirements of ‘skin in the game’ as proposed above, it would be prudent that the investors are aware of the risks associated with all mutual fund schemes,” SEBI says in the paper.
The market regulator previously mandated monthly disclosure of stress tests for small and midcap schemes on AMFI and AMC websites. This move was prompted by a surge in inflows and the rapid rise in small and midcap stocks. However, with recent corrections moderating returns, attention has shifted to sectoral and thematic schemes.
The key risk with sectoral and thematic funds lies in the flexibility granted to fund managers, who are not limited by exposure caps on individual stocks, unlike most actively managed equity schemes, which cap stock exposure at 10%. This lack of limits can expose investor capital to significant risks, especially when markets are volatile.
With retail inflows into these schemes accounting for 38.5% to 49% of total growth or equity-oriented mutual fund inflows in the last three months, and 68% of new fund offers from July to September being sectoral and thematic, the regulator now seeks stress test disclosures for these funds as well.
Additionally, the consultation paper covers eight key areas related to the interests of AMC employees and unit holders, focusing on easing compliance for AMC staff. It proposes relaxations, including a reduction in the mandatory minimum investments required from employees and a decrease in the frequency of salary disclosures, along with other adjustments to streamline requirements.