SEBI conducts stress test review of small, mid-cap funds through market volatility concerns

The unprecedented influx of investments into small and mid-cap funds over the past year has contributed to the escalation of stock prices within these segments, amplifying the risk of a substantial market correction in the event of adverse market conditions.

In response to surging inflows into mutual fund schemes investing in small and mid-cap stocks, India’s securities regulator, the Securities and Exchange Board of India (SEBI), is reportedly scrutinizing the resilience of these funds to potential market downturns or sudden withdrawals. According to two sources familiar with the matter, SEBI is evaluating whether these funds possess adequate liquidity to withstand significant outflows or sharp declines in stock prices.

The unprecedented influx of investments into small and mid-cap funds over the past year has contributed to the escalation of stock prices within these segments, amplifying the risk of a substantial market correction in the event of adverse market conditions. Discussions held with the Association of Mutual Funds in India (AMFI) this month revealed that SEBI has requested internal stress tests conducted by small and mid-cap funds to assess their liquidity positions and preparedness for adverse scenarios.

Although SEBI has concluded an initial round of stress test reviews, it has urged funds to simulate additional adverse scenarios to enhance their resilience, as per one of the sources familiar with the matter. Both sources, however, chose to remain anonymous due to the confidential nature of discussions with the regulator. When approached for comment, SEBI and AMFI refrained from responding to requests seeking clarification on the matter.

The robust economic growth in India has propelled significant gains in stock indices, with the benchmark BSE Sensex rising by 20% over the past 52 weeks. Concurrently, the BSE small-cap index witnessed a remarkable surge of 65%, while the mid-cap index soared by 59%, driven by investor interest in stocks perceived to offer substantial upside potential.

Record inflows have been recorded in small and mid-cap funds, according to the second source, with mutual funds specializing in small-cap stocks witnessing inflows totalling 432.8 billion rupees ($5.2 billion) in 2023, more than doubling from the previous year. Similarly, inflows into mid-cap funds rose by 20% to 248.8 billion rupees.

Mutual funds typically maintain cash reserves ranging between 1% and 5% of their assets as a precautionary measure to meet potential outflows, although there exists no minimum regulatory requirement. To be classified as small-cap funds, funds must invest a minimum of 65% of their assets in small-cap stocks, with the remainder allocated to cash or large-cap stocks, a rule which applies similarly to mid-cap funds.

Discussions have emerged regarding potential defensive measures to mitigate the impact of stress events, such as increasing cash reserves in portfolios and incorporating a buffer of large-cap stocks, according to one of the sources.