Reduce liquidity risk in smallcap, midcap funds with asset allocation

The results of the stress tests conducted by mutual fund houses in their mid and smallcap funds show that liquidity risk is higher in the latter category.

While the bulk of midcap funds that have declared their results will be able to liquidate 25 per cent of their portfolio within three days, only about half of the smallcap funds would be able to do so.

Higher awareness

One positive outcome of the stress test is the increased awareness.

“It has raised awareness at least among some investors that liquidity can be a concern in the mid and smallcap segment during times of stress,” says M Pattabiraman, associate professor, IIT Madras and founder, Freefincal.com.

Alekh Yadav, head of investment products, Sanctum Wealth adds that having access to regular data on liquidity will make investors more conscious of this risk.

Methodology issues 

Some experts have pointed to a couple of issues with the methodology employed to calculate the time for portfolio liquidation. One, funds are permitted to exclude the bottom 20 per cent of the least liquid stocks in their portfolios from calculations. This has the potential to skew results.

Another point of concern is the assumption that liquidity improves during volatile periods. Fund houses are allowed to assume a threefold spike in trading volumes during such times. Experts say in reality, trading volumes tend to dry up in such times. 

Should liquidity affect fund selection?

When selecting a fund, experts say investors should focus primarily on consistency of performance and quality of holdings. “Using any metric, such as liquidity, in isolation to evaluate a fund can lead to poor decisions. Investors have committed this error in the past with an expense ratio and risk-o-meter,” says Vidya Bala, co-founder, PrimeInvestor.

Instead of making binary decisions based on this criterion, investors may give some weight to it in their fund-making methodology.

Some experts believe AUM size could become an important criterion in the future.

“With test results showing that most larger-sized funds take longer to liquidate their portfolios, it may be prudent to stick to funds having a smaller AUM, especially in the smallcap space,” says Yadav.   

Control what you can

Direct stock investors can choose not to go with illiquid stocks.  Fund investors, however, will find it difficult to address liquidity risk at the fund level. When they invest in a fund, they must trust their fund manager to take calculated risks (including liquidity risk) to achieve the desired returns.

Investors can best manage liquidity (and other market) risks in small and midcap funds through their strategic asset allocation.

“Based on risk appetite, ensure that your investment in small- and midcap funds does not exceed 15 to 30 per cent of your equity portfolio,” says Bala.

Pattabiraman points out that fund liquidity is not within the investor’s control and can improve or worsen after they have invested. Avoid kneejerk reactions like exiting a fund if there is a spike.   

“Rebalance your portfolio regularly to maintain small and midcap exposure within the decided limits,” says Peterman Abhishek Kumar, a Sebi-registered investment advisor (RIA) and founder, SahajMoney.

Invest in small and midcap funds with a horizon of seven years or more so that you are not affected by intermittent spikes in volatility.

Act based on your own liquidity needs. “When you are one or two years away from a goal, liquidate the required amount from equity funds and park it in debt instruments to meet your requirements,” says Kumar.

Bala suggests creating an emergency fund using debt funds so that you don’t have to sell your equity holdings during a market downturn.

Pattabiraman says studies done by him have shown that most active smallcap and midcap funds struggle to consistently beat the Nifty Midcap 150 index.

He says investors (especially new ones) uncomfortable with the high liquidity risk in smallcap funds may avoid the category altogether. He suggests that those keen on midcap exposure should consider investing in a Nifty Next 50 index fund.

“This index has a risk-reward profile similar to that of a midcap index but has relatively better liquidity,” he adds.

Liquidity criterion: Key caveats

> Some funds require more days to liquidate their portfolios due to their larger assets under management, not necessarily because their holdings are less liquid

>  Liquidity is influenced by a smallcap fund’s allocation to smallcap stocks: Some hold the bare minimum required (65 per cent) and are more liquid while others hold more (and are less liquid)

>  Low liquidity doesn’t always mean poor fundamentals (quality stock can be illiquid due to high promoter holding)

> Smallcap fund managers seek to generate alpha by investing in undiscovered gems, which usually have low liquidity

> Excess focus on portfolio liquidity could make smallcap fund managers overly cautious, affecting the return generation potential of their funds