Liquidity concerns hit small cap funds, but how bad is it?

Under present market cycle, the key is to diversify, not go overboard in small caps or even mid-caps, said experts

- Anil Poste & Neil Borate

Many small-cap mutual funds managing large assets will likely need more days than usual to liquidate their portfolios if the need arises, according to the latest stress test data sourced by India's apex mutual fund body.

This crucial metric for stress tests, as mandated by Securities and Exchange Board of India, indicates higher liquidity risks in the small-cap segment even as investors flock to these stocks, lured by the promise of high returns.

According to some experts, a high liquidity risk could also point to the low quality of a fund's investments.

On average, the time required to liquidate 50% of a small-cap fund portfolio has increased by 39.4 days between the first such stress test conducted in February 2024 and the latest in January. The time needed to liquidate 25% of a portfolio has risen by 19.8 days.

Funds need to be able to liquidate portfolios to meet redemptions, rebalance holdings, or manage risks.

Longer liquidation times could delay investor exits, lead to distress selling at lower prices, impacting the net asset value of their holdings.