Sebi to introduce industry-wide stress test for small-cap funds soon

India's markets regulator is set to introduce an industry-wide stress test for small-cap funds, a significant shift from the previous round of fund-specific assessments, said Ananth Narayan, whole-time member of the Securities and Exchange Board of India (Sebi), in his speech at the Cafe Mutual Conference on Friday.

Narayan highlighted the remarkable growth in the mid- and small-cap segments, noting that over 40% of mid- and small-cap stocks have surged more than fivefold in the last five years.

While Sebi refrains from commenting on market valuations, Narayan emphasized that stakeholders should reflect on this rapid appreciation. He stressed that the regulator's role is not to predict or influence market trends but to ensure the robustness of the financial system.

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Addressing the gap

Previously, Sebi-mandated stress tests were conducted at the fund level, with each small-cap fund independently releasing the results of its assessment. This approach provided valuable insights into the resilience of individual funds but left a gap in understanding the industry's collective health. The upcoming industry-wide stress test aims to fill this gap, offering a more comprehensive view of the sector’s stability.

Narayan shared both encouraging and cautionary findings from Sebi's analysis. The good news is that, overall, the industry's stress levels have not escalated from March 2020 to March 2024 despite the significant market upheavals during the period. This suggests that small-cap funds have managed to maintain their stability even as market conditions have fluctuated.

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However, Narayan warned of a critical caveat: The increase in average daily traded volumes within the small-cap segment. This rise in volumes has been largely driven by a sustained inflow of funds into these stocks. While this has supported market liquidity and helped small-cap funds manage their portfolios, there remains uncertainty about what could happen if this demand diminishes. The potential for market stress increases significantly if liquidity dries up and selling pressures mount.

Narayan underscored the importance of suitability and appropriateness in the advisory process, particularly for mutual fund distributors (MFDs). Given the volatile nature of the small-cap segment, it is crucial for MFDs to ensure that these investments align with their clients' risk profiles and investment goals.

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As Sebi prepares to implement an industry-wide stress test for small-cap funds, the results will be closely watched by market participants. The findings will not only shed light on the sector's resilience but also guide investors and advisors in navigating the complexities of small-cap investing.