Evaluating equity funds is a welcome step

The Securities and Exchange Board of India (SEBI) is working to conduct comprehensive stress tests on equity mutual fund schemes (assessing whether the funds are in a position to repay if shares are sold) and adopt measures to deal with risky situations. This is a relatively new initiative by the market regulator but it will come after the first round of stress tests, the results of which are said to be unsatisfactory. There are good arguments for this policy move to introduce more comprehensive stress tests. Equity funds continue to inflow capital and most of the money comes from retail investors. Certainly most of the equity assets under management are in the retail portfolio. Not only this, the constant flow of funds forces the fund managers to buy more shares within their fixed limits, even if the market is bullish due to persistently high share prices.

If the market goes down people will start withdrawing their funds. In such a situation, it is possible that the fund will feel pressured to return the amount to the people as they have to return the money quickly. If the fund has to sell during a downturn in the market to meet this demand, this selling pressure can lead to further losses. If this happens, a trend toward gentrification will begin and a state of anarchy may arise. If this happens, it will prove detrimental to the unit holders of the schemes. Because smallcap and midcap stocks have less liquidity.

In such a scenario, a large amount of institutional selling can put downward pressure on prices. Even smaller stocks outside the futures and options category have circuit breakers that can suspend trading. If the business becomes impossible, it will be more difficult to withdraw the money.

Many asset management companies have already started taking proactive steps to avoid such situations. For example, they have stopped investing heavily in smallcap and midcap funds. Managing Systematic Investment Plan commitments is easy in every sense. But the regulator is apt to conduct more extensive stress tests to identify which schemes are at greater risk and identify points where stress conditions may arise.

If necessary, SEBI may also consider other measures, such as extending the period for withdrawal of funds from the fund or allowing short-term fund raising to avoid sudden withdrawals by the public. Another question arises of transparency. It has its own merits and demerits. The standards, structures and assumptions of stress tests can be complex and opaque.

Should the regulator publish the results of stress tests if funds are found to be at risk? If this happens, prudent investors will be able to withdraw their money in an orderly manner but it may cause panic. But investors will not get any help if the results are not declared. Regulators have to take a decision in this regard.

The nature of the stock market is cyclical. Every rise in the market is followed by a decline and these declines can also be very severe. Mutual funds are an important institutional sector and since they are directly accountable to retail investors, they can quickly come under stress if trends change. It would be better to prepare in advance for such situations.