India’s market regulator, the Securities and Exchange Board of India (Sebi), is planning to introduce a stress test that will apply to the entire small-cap fund industry, rather than just individual funds. This was announced by Ananth Narayan, a whole-time member of Sebi, during his speech at the Cafe Mutual Conference on Friday.
Narayan noted that mid- and small-cap stocks have seen significant growth, with over 40% of these stocks increasing more than five times in value over the last five years. Although Sebi doesn’t comment on market valuations, Narayan encouraged stakeholders to consider the rapid increase in these stock prices. He emphasized that Sebi’s role is not to predict market trends but to ensure the financial system remains strong.
Addressing the Industry’s Stability
Previously, Sebi required stress tests to be done at the individual fund level, where each small-cap fund would independently release its results. While this provided insights into how each fund might handle financial stress, it did not offer a full picture of the industry’s overall health. The new industry-wide stress test is designed to provide a more complete view of how stable the small-cap fund sector is as a whole.
Narayan shared both positive and cautionary findings from Sebi’s analysis. On the positive side, the industry’s stress levels have not increased from March 2020 to March 2024, even though the market has faced significant challenges during this period. This indicates that small-cap funds have managed to stay stable despite fluctuations in the market.
However, Narayan also pointed out a potential concern: the average daily trading volumes in the small-cap segment have risen, largely due to a continuous inflow of money into these stocks. While this has helped maintain market liquidity and allowed small-cap funds to manage their portfolios effectively, there is uncertainty about what might happen if this demand decreases. If liquidity dries up and selling pressure increases, the market could experience significant stress.
Narayan highlighted the importance of mutual fund distributors (MFDs) ensuring that small-cap investments are suitable for their clients’ risk profiles and investment goals, given the volatile nature of this segment.
As Sebi gets ready to implement the industry-wide stress test for small-cap funds, market participants will be watching the results closely. These findings will not only reveal how resilient the sector is but also provide guidance for investors and advisors in managing small-cap investments.
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