SmallCap Funds badly affected by stock market fluctuations

The level of liquidity pressure in most small-cap funds has increased in recent months due to the continued strength in investment despite high market volatility and pricing concerns. The level of liquidity pressure or distress indicates the number of days it will take for mutual funds to raise funds to repay liabilities in the event of heavy selling.
Funds have provided stress test data. This shows that at present it will take an average of 37 days for the 10 largest small cap funds to sell 50 per cent of their portfolio. In February 2024 this period averaged 29 days.

Liquidity pressure in quant smallcap funds has increased the most in the last 10 months. Earlier it was able to sell 50 per cent of its portfolio in 22 days but now this time has increased to 73 days. Liquidity pressure has also increased significantly in the smallcap schemes of HDFC MF and DSP MF. According to experts, the level of stress in itself is not a major concern but investors need to be cautious while investing in smallcap funds as other parameters like valuations are also not favourable.

Rishabh Desai, founder, Rupee with Rishabh Investment Services, said, “There is nothing to worry about as it is natural for smallcap funds to take more days to sell. The number of days also varies as market conditions change and when the market is unstable or in a downward trend, the number of days is likely to be higher.

Vishal Dhawan, Founder and CEO, Plan Ahead Wealth Advisors, said, “This is probably a result of the size of smallcap schemes increasing due to large-scale investments through both systematic investment plans (SIP) and lump sum. Although the pressure level is fine now, there is a need to keep an eye on it.
“Investors should consider this aspect but also look at other criteria like risk-return ratio and information ratio (performance ratio compared to the benchmark) while selecting a fund,” he said.

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Starting in 2024, market regulator Securities and Exchange Board of India (SEBI) made it mandatory for mutual funds to release stress test reports of their midcap and smallcap funds every month. The move is aimed at raising awareness about the risks associated with these funds amid rising investments in the midcap and smallcap sector and high valuations.

Following the SEBI directive, at the same time many mutual funds managing large smallcap funds had announced setting maximum limits for investment in such funds to ensure liquidity.

However, investment in midcap and smallcap funds is continuously increasing. These two categories account for about 30 to 40 percent of the net investment accounts opened in the active equity segment. Assets under management (AUM) of smallcap funds increased by 41 per cent to Rs 3.3 lakh crore in 2024 as a result of higher investments and mark-to-market gains. Meanwhile, the AUM of midcap funds increased by 42 percent on an annual basis to reach Rs 4 lakh crore in December 2024.

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