In light of potential sharp falls in stock prices or sudden outflows, India’s market regulator is reportedly scrutinizing the resilience of local mutual fund schemes investing in small and mid-cap stocks.

What Happened: A Reuters report on Monday revealed that the Securities and Exchange Board of India (SEBI) is in talks with the Association of Mutual Funds in India (AMFI) over the potential risks related to heavy inflows into such funds over the past year. The regulator has reportedly requested internal stress tests from these funds to evaluate their liquidity in case of large outflows.

The request from SEBI to review the results of these stress tests is an unusual occurrence. The regulator has already completed one round of reviews but is asking for additional tests for more severe scenarios, according to sources who chose to remain unnamed due to the confidential nature of the discussions.

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Small and mid-cap stocks have experienced significant price increases due to strong inflows, sparking concerns about a sharp market correction should conditions worsen. The BSE small-cap index has soared 65% and the mid-cap index has increased 59% over the past year, outpacing the 20% increase of the benchmark BSE Sensex.

Why It Matters: The review by SEBI comes amid a surge in small and mid-cap stocks, which have seen significant price increases due to strong inflows. This has raised concerns about a steep market correction should conditions deteriorate. The regulator’s request for additional stress tests indicates a heightened level of concern over the resilience of these funds. The outcome of these reviews could have significant implications for the mutual fund industry and investors, particularly if they result in tighter regulations or changes in investment strategies.

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