By Nirav Karkera
The markets regulator had flagged froth in the small-cap and midcap segment while referring to valuations in the space. The Association of Mutual Funds in India (Amfi) took note of the regulator’s concerns and aligned an action plan with the regulator’s key objective of investor protection.
It directed mutual funds to provide additional disclosures related to liquidity risks in small-cap and midcap funds. These disclosures are aimed at helping investors make more informed decisions by providing insights into less-known aspects of small-cap and midcap funds, such as liquidity profiles.
New set of disclosures
The new set of disclosures borrow a couple of data points from the existing factsheets that are in alignment with previous guidelines along with a couple of incremental data points. Risk metrics like Beta and Standard Deviation as well as allocation based on market capitalisation is already available in most factsheets.
New disclosures include details on how long it would take for the mutual fund to liquidate 50% and 25% of its portfolios and what proportion of assets is concentrated in the hands of the top 10 investors.
At the very outset, it seems imperative to offer our perspective on the exercise. Our initial impression is that the utility of outcomes are best categorised as indicative metrics and comparable measures. The method for stress-test is a hypothetical situation and is expected to analyse the situation if a theoretical scenario wherein the liquidity is stressed were to arise.
Liquidity profile
While these disclosures offer valuable insights, it is important to acknowledge the extent of its utility. We believe that the exercise serves well in terms of offering investors incremental insights on the liquidity profile of the funds, albeit in an indicative fashion. The other utility is that of standard comparability across funds.
The stress-test methodology is hypothetical and aims to analyse how liquidity would be affected in a theoretical scenario where liquidity is stressed. For instance, the midcap category would take an average of six days to liquidate half its portfolio after excluding the bottom 20%, while the small-cap category would take around 14 days for the same measure. However, these numbers assume a scenario of simultaneous redemption of 50% of the portfolio, which is highly unlikely. The low concentration of assets is indicative of a well-spread asset base which strengthens the case for assigning a low-likelihood probability to the hypothesis.
In practical terms, portfolios may not be liquidated based on pro-rated weights of constituents but rather based on liquidity. This could significantly reduce the average days required for liquidation. Additionally, mid-cap funds hold an effective 4.5% or Rs 13,150 crore in cash, while small-cap funds allocate 6% or Rs 15,225 crore to cash.
Both categories also hold 14% and 7.8% of their assets, respectively, in more liquid large-cap stocks. This prudent allocation to cash and liquid large-cap stocks enhances their ability to pursue gains while maintaining strong reserves for liquidity requirements, even in stressed situations.
The writer is head, Research, Fisdom