How India’s top 10 small cap mutual funds stand on liquidity stress test

India's top small-cap fund managers will require substantial time, in some cases up to 30 days, to liquidate a quarter of their portfolios during market upheavals, as revealed by stress tests conducted by various fund houses.

Fund houses would likely need between six days and 30 days to exit a quarter of their small-cap portfolio, and 12-60 days to liquidate half of the portfolio.

If a fund takes longer than two to three days to return investors' money, it suggests stress in the portfolio.

Market regulator Securities and Exchange Board of India (Sebi) initiated these stress tests following concerns about potential market bubbles, primarily fuelled by the overenthusiasm of retail investors.

Sebi had voiced apprehensions regarding the lofty valuations of small-cap and mid-cap stocks, advising money managers to cap inflows into these schemes.

This regulatory scrutiny comes at a time when the Nifty Smallcap 250 index has surged by nearly 60% in the past year, overshadowing the Nifty 50’s 28% gain. The sector, however, faced volatility recently, partly due to the Reserve Bank of India’s actions against significant financial players like Paytm, IIFL Finance, and JM Financial Products.

Following these developments, Sebi chairperson Madhabi Puri Buch had said that by March 15, the regulator would introduce a stress testing disclosure format for small- and mid-cap funds. This move aims to provide investors with clarity on the potential liquidation timeline of these funds under adverse market conditions.

Stress test outcomes

Nippon India Small Cap Fund, the largest of its kind with ₹46,004 crore in assets under management (AUM), would need 27 days to liquidate half of its portfolio and 13 days for a quarter under stress conditions. The fund has not limited lump sum inflows but restricted systematic investment plans (SIPs) to ₹5 lakh.

HDFC Small Cap, the second-largest with an AUM of ₹28,599 crore, would require 42 days for half and 21 days for a quarter of its portfolio. Currently, it imposes no restrictions on investor inflows. About 3% of the scheme’s AUM is held by top10 investors.

SBI Small Cap would need 60 days for half and 30 days to offload a quarter of its portfolio. The fund allows SIPs up to ₹25,000 per month per investor, with no lump sum restrictions.

For Axis Small Cap, the liquidation would need 28 days for 50% of the portfolio and 14 days for 25% of the portfolio. There are no restrictions on investor flows right now.

Quant Small Cap would take 22 days to offload 50% of its portfolio and 11 days for 25% of the portfolio. There are no restrictions on investor flows right now.

For Kotak Small Cap, it will take 33 days to liquidate 50% of the portfolio and 17 days for 25%. For Kotak Small Cap Fund, lumpsum investments are allowed up to ₹2 lakh, while SIPs are allowed up to ₹25,000 per month/per investor.

For HSBC Small Cap, it will take 14.5 days for 50% liquidation of the portfolio and 7.25 days for 25% of the portfolio.

For DSP Small Cap, which invests primarily in micro-cap companies, liquidation of 50% of the portfolio would need 32 days and 16 days for 25%.

For Franklin India Smaller Companies, the liquidation would need 12 days on 50% of the portfolio and 6 days on 25% of the portfolio.

For Canara Robeco Small Cap Fund, the liquidation would need 13.5 days on 50% of the portfolio and 6.75 days on 25% of the portfolio.

On the above four schemes, there are no investor flow restrictions right now.

Implications of the stress test

The stress test methodology considered a scenario with only 10% market participation for the schemes, assuming the average traded volume observed over three months would triple during stress periods. Mutual funds were given a concession to exclude the least liquid 20% of their portfolio by weight from the liquidation calculation.

The findings underscore the need for investors to understand the liquidity dynamics of small-cap funds, especially during turbulent market conditions. These results also highlight the significant variability in liquidation capabilities among funds, influenced by portfolio composition and market conditions.