WHAT STRESS TESTS MEAN FOR
YOU
Reduce risk in small, midcap
funds with asset allocation
The
results of the stress tests conducted by mutual funds houses in their mid and
smallcap funds show that liquidity risk is higher in the latter category.
While
the bulk of midcap funds that have declared their results will be able to
liquidate 25 per cent of their portfolio within three days, only about half of
the smallcap funds will be able to do the same.
One
positive outcome of the stress test is the increased awareness.
It
has raised awareness at least among some investors that liquidity can be a
concern in the mid and smallcap segment during times of stress. Wealth adds
that having access to regular data on liquidity will make investors more
conscious of this risk.
Methodology
issues
Some
experts have pointed to a couple of issues with the methodology employed to
calculate the time for portfolio liquidation. One, funds are permitted to
exclude the bottom 20 per cent of the least liquid stocks in their portfolios
from calculations. This has the potential to skew results.
Another
point of concern is the assumption that liquidity improves during volatile
periods. Fund houses are allowed to assume a threefold spike in trading volumes
during such times. Experts say in reality, trading volumes tend to dry up in
such times.
Should
liquidity affect fund selection?
When
selecting a fund, investors should focus primarily on consistency of
performance and quality of holdings. Using any metric, such as liquidity, in
isolation to evaluate a fund can lead to poor decisions. Investors have
committed this error in the past with expense ratio and risk –o-meter.
Prime
Investor
Instead
of making binary decisions based on this criterion, investors may give some
weight to it in their fund selection methodology.
Some
experts believe AUM size could become an important criterion in the future.
With
test results showing that most larger-sized funds take longer to liquidate
their portfolios, it may be prudent to stick to funds having a smaller AUM,
especially in the smallcap space.
Control
what you can
Direct
stock investors can choose not to go with illiquid stocks. Fund investors, however,
will find it difficult to address liquidity risk at the fund level. When they
invest in a fund, they must trust their fund manager to take calculated risks
(including liquidity risk) to achieve the desired returns.
Investors
can best manage liquidity (and other market) risks in small and midcap funds
through their strategic asset allocation.
Based
on risk appetite, ensure that your investment in small and midcap funds does
not exceed 15 to 30 per cent of your equity portfolio.
Points
out that fund liquidity is not within the investor’s control and can improve or
worsen after they have invested. Avoid kneejerk reactions like exiting a fund
if there is a spike.
Rebalance
your portfolio regularly to maintain small and midcap exposure within the decided
limits.
Invest
in small and midcap funds with a horizon of seven years or more so that you are
not affected by intermittent spikes in volatility.
Act
based on your own liquidity needs. When you are one or two years away from a
goal, liquidate the required amount from equity funds and park it in debt
instruments to meet your requirements.
Create
an emergency fund using debt funds so that you don’t have to sell your equity
holdings during a market downturn.
Studies
done by him have shown that most active smallcap and midcap funds struggle to
consistently beat the Nifty Midcap 150 index. Investors (especially new once)
uncomfortable with the high liquidity risk in smallcap funs may avoid the
category altogether. Those keen on midcap exposure should consider investing in
a Nifty Next 50 index fund.
This
index has a risk-reward profile similar to that of a midcap index but has
relatively better liquidity.
LIQUIDITY CRITERION : KEY
CAVEATS
Ø Some funds require more days to liquidate their portfolios due to their larger assets under management, not necessarily because their holdings are less liquid
Ø Liquidity is influenced by a smallcap fund’s allocation to smallcap stocks: Some hold the bare minimum required (65 per cent) and are more liquid while others hold more (and are less liquid)
Ø Low liquidity doesn’t always mean poor fundamentals (quality stock can be illiquid due to high promoter holding)
Ø Smallcap fund managers seek to generate alpha by investing in undiscovered gems, which usually have low liquidity
Ø Excess focus on portfolio liquidity could make smallcap fund managers overly cautious, affecting the return generation potential of their funds
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