Are your mid- and small-cap funds under stress?

What good is an investment if you can't sell it well? This holds true for both individual investors and mutual funds alike. Since mutual funds hold stock portfolios, the ability to sell or exit these stocks at the right time is a crucial aspect to be considered.

Stocks with low liquidity can be challenging to sell, especially in the volatile segment of mid- and small-caps. This is because most stocks in these segments do not always enjoy healthy trading volumes on the exchanges. In light of this, the Securities and Exchange Board of India (SEBI) has advocated (through reports only) for thorough liquidity stress testing for mutual funds focusing on mid- and small-cap stocks.

SEBI's concern

Following an extraordinary rally in mid- and small-caps last year, the mid and small-cap funds delivered massive returns of 40 and 45 per cent, respectively, in 2023. This impressive performance led to investors pouring a whopping Rs 63,949 crore into these funds.

However, historically, a hit year in mid- and small-cap funds has typically been followed by lukewarm returns by these funds. If this trend repeats, SEBI worries whether these funds can withstand large-scale outflows.

For instance, we analysed trading volumes of mid- and small-cap stocks during market stresses, such as those experienced during the COVID-19 pandemic. We included mid-cap stocks and the top 500 small-cap stocks as of the end of 2019 and compared their average trading volumes in 2019 with those in March 2020.

We found that:

• 69 out of 150 mid-cap stocks experienced a more than 25 per cent increase in trading volumes. Only 31 stocks saw a reduction of over 25 per cent.
  
• About 51 per cent of the small-cap stocks saw a decrease in trading volume by more than 25 per cent.

These figures, especially in small-cap stocks, might raise concerns. That's where the stress testing comes into the picture.

What is liquidity stress testing?

To mitigate the liquidity risk in mutual funds, SEBI requires mutual funds to perform thorough liquidity stress tests. It is a test to gauge the fund's capacity to sell (or exit) stocks when it wants to without incurring significant losses.

Fund houses have also adopted measures such as maintaining cash and debt positions. As of January 31, 2024, mid-cap funds had 3 per cent of their assets in cash and debt, while small-cap funds had 6 per cent. Moreover, only 7 out of 29 mid-cap funds had less than 10 per cent exposure to large-cap stocks (they offer higher liquidity). In contrast, 19 out of 27 small-cap funds held less than 10 per cent exposure to large-cap stocks. Further, fund managers believe that a quality stock can always be sold in block deals, irrespective of the liquidity.

AMCs are also limiting inflows into specific schemes. For example, SBI Mutual Fund has stopped accepting lump sum investments into its small-cap schemes for several years now.

However, it is essential to note that there hasn't been an instance where mid- and small-cap funds (or equity funds) have faced difficulties meeting necessary redemptions. Further, the market capitalisation of these stocks has risen in tandem with fund inflows, keeping the investment-to-market cap ratio stable over the last five years. This balance suggests a lower level of concern for liquidity-related issues.

Our word

Be on the safer side and:

• Maintain a long-term investment horizon of at least seven years for mid- and small-cap funds.
  
• Avoid allocating emergency funds to these funds.
  
• Allocate 20-30 per cent in mid-cap and 10-20 per cent in small-cap funds. Rebalance regularly to maintain the desired allocation.

Also watch: How to pick the hottest small-cap fund?