Market quicksand: Smallcap mutual funds trapped in deep liquidity mud

Weak market sentiment until February has eroded stock trading volumes over the past five months, straining liquidity in smallcap mutual fund (MF) schemes. 

 

Stress test data shows that the 10 largest smallcap schemes now take an average of 37 days to liquidate half their portfolios, up from 28 days in September 2024. This increase came despite nine of these schemes raising cash reserves, shifting towards largecaps, or both during the market correction.

 

The drop in trading volumes is evident in the daily average cash turnover, which fell to Rs 93,000 crore in February 2025 across both exchanges — the lowest since November 2023. The market has been on a downtrend since late September 2024, with benchmark indices declining for five straight months through February 2025. The Nifty 50 lost nearly 15 per cent from its peak by February 28, while the Nifty Midcap 100 and Nifty Smallcap 100 tumbled over 20 per cent.

 

“The test factors in average volumes from the past three months. With trading activity down, the results now reflect greater liquidity strain,” said Resham Jain, fund manager at DSP MF.

 

Rushabh Desai, founder of Rupee With Rushabh Investment Services, attributed the same reason to the rise in stress.

 

“Smallcap funds naturally take longer to exit positions. The timeline varies with market conditions and tends to stretch during volatility or corrections,” he said.

 

Most large smallcap schemes have seen liquidity pressures build since the first stress test report was published in February 2024. Before the market downturn, strong inflows were the primary driver.

  Investor interest in smallcap and midcap funds has been strong for two years, with these segments accounting for 30-40 per cent of net investment account openings in active equity. Robust inflows, coupled with mark-to-market gains, lifted smallcap funds’ assets under management (AUM) by 41 per cent in 2024 to Rs 3.3 trillion. Midcap funds’ AUM expanded 42 per cent year-on-year to Rs 4 trillion as of December 2024.     

However, with most new folios now in the red due to the correction, inflows into midcap and smallcap funds dropped to a four-month low of Rs 7,130 crore in February.

 

At the scheme level, 21 of 28 smallcap funds reported longer liquidation times, with HDFC and DSP smallcap funds seeing the sharpest increases.

 

This is despite a lower percentage of smallcap holdings in nine of the 10 largest portfolios compared to September 2024. The biggest scheme — Nippon India Smallcap Fund — reduced its smallcap allocation to 57.2 per cent by the end of February from 70.4 per cent in September.

 

Most of this reduction happened in February, with proceeds largely parked in cash. The schemes’ cash holdings climbed to 17.5 per cent, up from 4 per cent five months ago. It remains unclear whether this buildup is a strategic move or the result of portfolio churn.

 

Two major schemes — SBI Smallcap Fund and Quant Smallcap Fund — shifted further into largecaps during this period.

 

SBI MF increased its largecap allocation from about 2 per cent to over 9 per cent, while Quant MF raised exposure to 26 per cent from 21 per cent. 

 

A liquidity stress test assumes a pro-rata liquidation approach, excluding the 20 per cent least liquid holdings. It also factors in a 10 per cent participation volume and three times the average trading volume for assessment.