The Indian mutual fund industry has witnessed an impressive surge in investor participation over recent years, with small cap funds attracting significant attention from risk-seeking investors. These funds
The Indian mutual fund industry has witnessed an impressive surge in investor participation over recent years, with small cap funds attracting significant attention from risk-seeking investors. These funds promise potentially higher returns by investing in emerging and lesser-known companies. However, the latest stress test reports reveal a crucial aspect investors should not ignore — liquidity risk.
According to the stress test results for March 2025, it could take between 25 and 57 days to liquidate 50 percent of a small cap fund’s portfolio during a market crisis. The findings bring to light the potential challenges in redeeming investments quickly from small cap schemes in volatile market conditions, raising concerns about liquidity management within this popular mutual fund category.
Small cap mutual funds primarily invest in companies ranked below the top 250 by market capitalization. These funds are known for delivering superior returns during market rallies but are equally susceptible to sharp corrections during market downturns.
In March 2025, despite market volatility, small cap funds recorded a net inflow of Rs 4,092 crore. This pushed the total net inflow for the fiscal year to Rs 41,673 crore, reflecting the continued interest of retail and institutional investors in this high-risk, high-return segment. However, over the past six months, small cap schemes experienced a notable 15.7 percent decline, the largest drop among diversified equity fund categories.
The Securities and Exchange Board of India (SEBI) introduced mandatory monthly stress tests for small and mid-cap funds starting March 2024. These tests require asset management companies (AMCs) to disclose how long it would take to liquidate 25 percent and 50 percent of their portfolios under simulated crisis scenarios, excluding the 20 percent least liquid assets.
The stress tests aim to provide investors with a transparent view of the liquidity profile of their mutual fund investments, especially in categories like small cap funds, where market volatility can significantly impact the ability to exit positions promptly.
As per the March 2025 data published on the Association of Mutual Funds in India (AMFI) website, the liquidation timelines have extended noticeably compared to February 2025 results, raising red flags about increasing liquidity risks.
The stress test findings varied across different fund houses, indicating differing levels of liquidity risk management and asset allocation strategies.
Axis Small Cap Fund: It would take approximately 25 days to liquidate 50 percent of its portfolio and 13 days for 25 percent. This is a noticeable increase from February 2025, where it required 12 days for a 25 percent liquidation.
HDFC Small Cap Fund: The fund faces higher liquidity constraints, needing 57 days to liquidate half of its portfolio and 28 days for a quarter.
DSP Small Cap Fund: Heavily invested in small cap stocks, accounting for 89 percent of its portfolio, this fund’s liquidity risk is considerably higher.
Quant Small Cap Fund: Among the most illiquid in the segment, the fund would need 73 days to liquidate 50 percent of its assets during market stress.
These results highlight significant disparities in liquidity profiles, reinforcing the importance of assessing not just returns but also liquidity conditions before investing in small cap mutual funds.
One of the most concerning trends is the sharp increase in liquidation periods compared to the stress test reports from February 2025. Back then, the maximum period to liquidate 25 percent of portfolios was 36 days. In March, many funds surpassed this benchmark for 50 percent liquidations, and even the time taken to liquidate 25 percent has increased across several schemes.
For instance, Axis Small Cap Fund required 12 days for a 25 percent liquidation in February, while in March, this extended to 13 days. Similar trends were seen in DSP and HDFC funds. This indicates rising liquidity risks amid fluctuating market conditions and increased investor participation in small cap funds.
Liquidity risk is a critical factor often overlooked by mutual fund investors, particularly in high-risk categories like small cap funds. In situations where market sentiment turns negative, and a large number of investors rush to redeem their units, the fund may struggle to liquidate its holdings promptly without impacting its Net Asset Value (NAV).
Investors relying on small cap funds for short to medium-term goals should carefully reconsider their strategies in light of these stress test results. Prolonged redemption periods could disrupt liquidity plans during emergencies or market downturns.
Moreover, while small cap funds can offer impressive returns in bullish markets, the increased liquidation period signals heightened risk exposure, which may not suit conservative or moderately aggressive investors.
The rising liquidation periods have put fund managers on alert. To manage liquidity risks effectively, AMCs are expected to reassess their asset allocations, maintain adequate cash reserves, and possibly reduce exposure to the most illiquid stocks in their portfolios.
Some fund houses may also introduce temporary restrictions or exit loads during volatile market phases to control sudden outflows and protect remaining investors.
The SEBI-mandated stress tests and monthly disclosures are commendable steps towards enhancing transparency in the mutual fund industry. By requiring fund houses to exclude the bottom 20 percent most illiquid assets from stress test calculations, SEBI ensures that the reported data offers a more realistic view of the funds’ liquidity positions under pro-rata stress scenarios.
For investors, these disclosures serve as essential tools to evaluate the risks associated with their mutual fund holdings. Regularly reviewing these stress test results can help investors make informed decisions, align their investments with their risk tolerance, and avoid potential pitfalls during market downturns.
Source : Business Today
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