Liquidity has been scarce in Indian capital markets in recent weeks. Mutual funds have also not been spared the pain, with liquid and money market funds seeing significant outflows over the past two months. Equity funds have been spared so far, apart from sporadic exits. However, if the ongoing sell-off in the equity market continues, equity funds may not remain immune to redemption pressure. Is the liquidity position of funds, particularly in the mid- and small-cap space, healthy enough to face exits or are they vulnerable to sell-offs? The liquidity profile of a mutual fund indicates how easily the shares can be unloaded in the market without significant loss of value for the investor. If a fund has too many illiquid stocks in its portfolio, the fund manager will be in a spot if faced with large-scale redemptions. Liquidity position of small-cap funds has deteriorated sharplyThe liquidity score indicates the number of days a fund will take to liquidate its entire portfolio.
The number of stocks held by a fund in one security is divided by the average daily trades on both NSE and BSE during the past six months. The exposure of the stock within the fund is taken as the weight to arrive at the final score. Source: CRISILTwo years ago ET Wealth had pointed out how a few mid- and small-cap funds had seen their liquidity profile deteriorate over a one-year period. At that time, midand small-cap funds had been scorching the performance charts as equity markets scaled new heights. Attracted by the returns, investors kept pouring money into these funds. This is when some fund managers may have sidelined liquidity health in favour of higher returns. Faced with influx of money amid relentless uptick in prices, a few fund managers resorted to hunting lower down the market capitalisation ladder in search of high alpha ideas. But in the mid- and small cap segment, not many stocks enjoy sufficient trading volumes at the stock exchanges, apart from the creamy layer comprising a few quality stocks. The quality dilution in the portfolio pushed the funds towards a potential liquidity trap. Some funds had a liquidity score in excess of 25 days at the time, implying that the scheme would take as many days to liquidate the entire portfolio. However, liquidity was not much of a concern then as markets were on a roll and interest in these stocks was elevated. But in the event of a sustained sell-off in equity markets, equity fund investors may also start heading towards the exit door. In this event, these funds could be staring at a liquidity trap. Volumes across stocks will dry up fast, leaving fund managers scrambling to find a way out. Data from CRISIL shows that compared to December end last year, the liquidity score of mid-cap funds increased marginally but that of small-cap funds climbed sharply. Small- cap funds would take an average of 18 days to liquidate their entire portfolios, compared to 10 days at the end of last year. Some funds will need in excess of 30 days to turn their investments into cash. This does not bode well for investors in these funds. “Rising liquidity scores of small-cap funds can be attributed to the recategorisation exercise in addition to tight liquidity for the underlying stocks because of sustained sell-off in the equity market,” explains Jiju Vidyadharan, Senior Director, CRISIL Research. After recategorisation, smallcap funds were mandated to invest 65% of their assets in stocks beyond the top 250 companies by market cap. Most funds from the mid- and smallcap basket have steadily increased cash holdings since April. This can be handy for meeting redemption requests. But if redemptions rise beyond normal—exits tend to rise sharply in a falling market—fund managers would be forced to meet the cash requirement by either selling some of the better performing stocks that have enough liquidity, or dumping liquidity-starved stocks at lower prices. Both are undesirable scenarios, but the latter can particularly hurt the fund’s return profile. Any drop in funds’ net asset value due to market slide will be further exacerbated if investors decide to make a beeline for the exit. The actual realisable NAV of the fund may be lower than the current NAV due to this liquidity overhang. Already, this is showing up in certain funds and may get accentuated if investors pull out, says Prateek Pant, Head of Products and Solutions, Sanctum Wealth. “Several mid and small-cap funds have taken a bigger hit than the index in this sell-off. Higher impact cost has dragged down NAV of these funds as illiquidity has risen.” Many funds have avoided falling into the liquidity trap by cutting off the flow of money either partially or entirely for a brief time. Mirae Asset Emerging Bluechip, SBI Small and Mid Cap (now SBI Small Cap), DSP BlackRock Micro Cap (now DSP Small Cap) were amongthe schemes that stopped accepting incremental flows for a while. This allowed the fund managers to manoeuvre the portfolio through a heated market without having to worry about deploying additional money. “Cutting out lumpy flows would have helped in preserving the liquidity profile of the funds and help contain large-ticket redemptions in the event of sell-off,” says Kaustubh Belapurkar, Director-Fund Research, Morningstar Investment Advisor. Some of these funds have only recently reopened for fresh subscriptions, having found more buying opportunities after the sharp correction. Other funds still face an uphill battle ahead. Even if the sell-off subsides, investors should be wary and avoid blindly chasing higher returns without caring for the sanctity of the portfolio. Liquidity risk is a critical element when investing in a mid-cap or small-cap portfolio.
Read more: economictimes.indiatimes.com