The downturn has inevitably weighed on smallcap mutual funds, which had attracted heavy inflows in 2024 amid euphoric market conditions. As markets cooled, smallcap funds faded from investor conversations while regulators and industry participants stepped up efforts to temper return expectations and rein in excess enthusiasm.
However, the core issue that propelled smallcap funds into the spotlight in late 2023 continues to persist. Liquidity stress across schemes has intensified over the past year, with conditions appearing stretched for several offerings.
Quant Small Cap Fund, the fourth-largest scheme in the category with assets under management of ₹27,355 crore, said in its latest stress-test disclosure that it would take 102 days to liquidate 50 per cent of its portfolio — more than double the time required in January 2025.
Smallcap schemes of HDFC MF, SBI MF, Tata MF, and DSP MF have also reported that they would need more than 50 days to sell half their holdings during periods of market stress.
The average number of days required by the top five schemes to sell half their portfolio has nearly doubled (62.6 days compared with 35.8 in February 2024) since the industry first released the stress test report.
Monthly stress test reporting was made mandatory by the Securities and Exchange Board of India (Sebi) following growing valuation and liquidity concern in the midcap and smallcap space amid record flows into MF schemes that predominantly invest in these segments. The tests were ordered to ensure smallcap funds could handle a rush of redemptions without causing a serious downturn in the market.
The concern and the growing regulatory scrutiny in late 2023 and early 2024 had even led most large schemes to stop accepting lump sum inflows and put a cap on systematic investment plan (SIP) investments.
The situation has improved since then. A combination of price and time correction post-September 2024 has eased valuation concerns and, in recent months, led to some moderation in MF inflows into smallcap and midcap schemes.
However, the liquidity situation of large smallcap schemes continues to deteriorate, going by the stress test reports. The rise in the number of estimated sessions needed to partially liquidate smallcap portfolios, experts say, is natural in the current environment considering the growing size of schemes. A decline in trading volumes in select pockets has also pushed up the estimated liquidation periods.
“The estimated time required to sell half the portfolio will depend on a few factors. The first is obviously the size of the fund. Second is whether the fund manager is true to the label — if a smallcap fund keeps buying only smallcaps as assets grow, liquidity pressure naturally rises. Third is the style of investing — a concentrated portfolio will show higher liquidity stress than one with wide diversification. Lastly, market conditions matter. In corrections, volumes fall, but delivery and block trades increase, so actual execution may not be as difficult as headline data suggests,” said a fund manager of one of the large smallcap schemes.
‘Avoid simplistic reading’
Are investors better off avoiding oversized smallcap funds? While larger schemes may appear riskier based on stress test data, experts caution against a simplistic reading of the numbers. They argue that stress tests offer only a broad indication of potential liquidity risk under standardised assumptions and do not fully capture how fund managers would respond in an actual crisis.
“In practice, fund managers do not follow such a mechanical approach during periods of stress. In a severe redemption scenario, the natural response is to exit the most liquid assets first, which typically include cash holdings and largecap exposure. These can be liquidated quickly with minimal market impact, so actual liquidation timelines may be shorter than what the stress tests suggest,” said Feroze Azeez, joint chief executive officer, Anand Rathi Wealth.
A look at the smallcap fund portfolios shows that most schemes can process redemptions amounting to 10-30 per cent of the AUM without having to sell any of their smallcap stocks.
Regulations allow smallcap funds to invest up to 35 per cent of their corpus in mid and largecap stocks, in addition to maintaining a portion in cash.
This approach, however, may not be fair for all investors. There is a reason why the stress tests assume pro-rata liquidation. “While it is not mandatory for asset management companies (AMCs) to sell securities on pro-rate basis (ie sell securities in the same ratio as the portfolio composition), for the purpose of stress test it is assumed that MF scheme will sell the securities on pro-rata basis to ensure equal treatment to all investors of the scheme,” the stress test reports state.
Hence, the issues that investors may face during periods of market crisis will depend on the severity of the dislocation, the approach that the fund manager takes and how investors behave collectively. The scheme’s current positioning will also be a key factor.
The odds of investors losing capital or taking a major hit in returns are much higher as opposed to facing a liquidity challenge, experts say.
“In the smallcap segment, a market correction typically leaves a far deeper dent in returns than the inherent liquidity of the portfolio. While a certain percentage of illiquid stocks is a structural reality and can act as a drag during steep downturns, these corrections also naturally recalibrate weights and present buying opportunities at significantly lower valuations.
Attempting to time exits based on the liquidity challenges of a few stocks is often futile; the real safeguard is a well-diversified portfolio. The highest risk remains the combination of a concentrated smallcap strategy paired with a very large AUM,” said Rahul Jain, senior vice-president research, International Money Matters.
According to the fund manager quoted previously, the liquidity situation as evident from average volumes may not always be a true representation of the quantum of stocks that are sold in a day.
“During bear phases, even a mild correction in smallcaps can make volumes appear to vanish. But what people often overlook is that delivery volumes actually rise in such periods, as transactions are driven by genuine buyers and sellers. While headline traded volumes may decline, execution quality improves. In stressed markets, block deals also pick up, so actual liquidity can be better than what the stress test framework captures,” he stated while requesting anonymity.
Size not the only factor
A look at the portfolios of smallcap funds shows that while size is a factor, the scheme’s stock selection and strategy are the key determinants of the liquidity scenario. For example, Nippon smallcap fund ranks sixth in liquidity stress despite managing the largest AUM of ₹66,000 crore. Quant MF, which reported the highest liquidity stress, is comparatively much smaller with ₹27,350 crore AUM. This is despite Quant’s smallcap fund maintaining the second-highest allocation in non-smallcap stocks among the 10 largest schemes.
Experts point to its significant allocation in several sub-₹10,000 crore free float market capitalisation (mcap) companies as the reason behind the swelling pro-rata liquidation period. Almost half of its top-15 holdings — Aegis Logistics, SUN TV Network, Poly Medicure, Ventive Hospitality, HFCL, Bikaji Foods International and Capri Global Capital — had a free-float mcap of less than Rs 10,000 crore as of February 23, shows NSE data.
The liquidity stress is comparatively lower in midcap schemes. The average number of sessions required to sell 50 per cent of the portfolio by the five largest schemes stood at 25.8 last month compared with 20.6 in January 2025.
According to Azeez, while liquidity is a crucial factor in midcap and smallcap schemes, the way to manage the risk is to maintain a diversified portfolio. “The more appropriate approach is to assess midcap exposure at the portfolio level. Aligning allocations with a balanced structure helps manage liquidity and volatility risks more effectively. Ideally, midcaps should constitute around 20 to 25 per cent of the overall equity portfolio. Maintaining exposure within this range allows investors to benefit from growth potential while keeping risk at manageable levels,” he said.