Small-cap funds face a higher liquidity risk. But all may not be unwell.

Several 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 the Securities and Exchange Board of India, indicates higher liquidity risks in the small-cap segment even as investors flock to these stocks, lured by their 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 can delay investor exits, lead to distress selling at lower prices, impacting the net asset value of their holdings.

“If a fund’s size grows substantially, or it gets a very large percentage of assets in a short period of time, it can become very challenging for the manager to continue running the fund in the same way as before," said Kaustubh Belapurkar, director–fund research at Morningstar Investment Research India Pvt. Ltd. 

“They may need to either dilute the mandate by buying more stocks or start moving up the market cap curve and buying larger-cap names to manage liquidity. And that’s not ideal, because that’s not why the investor gave them the money in the first place."

To counter such potential risks, many small-cap funds have adopted a ‘soft close’ strategy,