Should small-cap funds' stress test results worry you?

There's a ripple of activity among mutual fund investors as fund houses (AMCs) reveal how promptly their small- and mid-cap schemes can liquidate their holdings. The need for stress test Mid- and small-cap stocks had a stellar 2023, attracting significant investor interest to the tune of around Rs 64,000 crore, making SEBI sit up and take notice. The markets regulator was concerned whether these funds could sell stocks when they wanted to and without incurring significant losses. Soon, AMFI directed fund houses to take proactive measures. Given the mammoth surge in flows, the regulators' worries are natural. But should this stop you from investing in small- and mid-cap funds? We don't think so . We believe mid and small caps are a great idea in a growing economy like India as they typically represent the country's spirit of enterprise. Having said that, one can't ignore the underlying risks. Liquidity woes Unlike large-cap funds, mid- and small-cap segments face an inherent liquidity mismatch, more so when their asset size increases. A small-cap fund is bound to invest in small companies. Smaller-sized companies usually face liquidity issues, as buying and selling their shares in large quantities is often difficult. For example, while a small-cap fund manager can buy 50,000 shares of a small-size company, it may be difficult for them to buy 5 lakh shares. Besides, selling shares of a small company may result in a drastic fall in its price. Therefore, a fund manager needs to take care of the buying and selling decisions in a fairly measured way. Stress 'test' buster AMCs have been mandated to run a liquidity analysis based on a specific methodology. It considers the average daily trading volume of a stock in the last three months to evaluate how many days it would take for the fund to sell off its positions in a stock. So, AMCs have started disclosing their stress test result, meaning how quickly their small-cap and mid-cap funds can sell 25 per cent and 50 per cent of their holdings. The table below provides the stress test results of our recommended small-cap and mid-cap funds. What we found is that these funds do take more time to liquidate than their peers. Click here to get the stress test results of other funds. Here's how our recommended funds have fared on stress tests Fund name Category AUM (Rs cr) No. of days to liquidate 25% of the portfolio No. of days to liquidate 50% of the portfolio Kota