Stress Testing: Mutual fund stress testing provides valuable insight, but cannot be the sole basis for investment decisions.
These disclosures are reported on a monthly basis and assess the liquidity of portfolio stocks over the past three months.
This provides the estimated number of days needed to liquidate 25% and 50% of the portfolio. However, when estimating the time to liquidation, 20% of the least liquid securities in the portfolio are excluded from the analysis. Therefore, this method only provides an indicative profile of portfolio liquidity compared to other similar portfolios.
The analysis also assumes a trading volume equivalent to 10% of the average daily trading volume over the past three months for portfolio liquidation, which may vary significantly in real market scenarios.
Additionally, the disclosure includes the AUM share of the top 10 clients in the mutual fund scheme. These aspects highlight the customer concentration risk of investments. However, larger and more established fund houses have lower customer concentration risk than smaller fund houses due to their larger AUM.
Larger funds require significantly more days to liquidate assets, so this information may not provide much insight into the liquidity risk of the portfolio. Allocation based on portfolio, portfolio beta and market capitalization. Standard deviation and beta are statistical indicators used to understand the return profile of a portfolio. Standard deviation indicates the volatility of returns relative to the average return, while beta measures the sensitivity of a portfolio’s returns compared to the market as a whole.
These two indicators have been widely used by investors to evaluate the risks and returns associated with an investment.
While these disclosures provide additional insight to mutual fund investors, it is important to recognize that the information presented in stress test results is theoretical and may differ significantly from market reality for most funds. The stress test assumes significant withdrawal. However, in stressful scenarios, investors usually pause new investments in the stock market, while large withdrawals are rarely observed.
Mutual funds also have the flexibility to allocate investments across stocks based on market capitalization and also hold a portion of cash, which further impacts liquidity in case of withdrawals. Funds can adjust their portfolio allocations by liquidating the most liquid securities, ultimately reducing the number of days it takes for them to stabilize.
These disclosures also do not accurately depict stress scenarios because they do not take into account changes in the market value of securities in such scenarios and their impact on portfolio NAV values. In real-world circumstances, security prices tend to fall sharply during crises, and the liquidity of securities may also change. By considering only one aspect of a potential event, stress tests can oversimplify the impact of a crisis on investments.
Accordingly, stress test results should only be viewed as providing additional insight into a fund and should not be used alone in making investment decisions.
(The article’s author, Yashovardhan Khemka, is senior manager of research and analytics at Abans Holdings.)
