Small-cap mutual funds have grown popular for their long-term return potential, but they carry a risk that's easy to overlook: liquidity. SEBI, India's market regulator, periodically reviews disclosure norms for these funds because small-cap stocks can be thinly traded, making it harder for a fund to exit positions smoothly during periods of market stress.
Why liquidity risk is different for small-caps
Large-cap stocks typically trade in high volumes every day, so a fund can buy or sell a meaningful position without significantly moving the price. Many small-cap stocks trade far less frequently. If a fund holds a large stake in a thinly traded stock and investors rush to redeem units during a downturn, the fund manager may be forced to sell into a falling, illiquid market — potentially at unfavourable prices.
What regulators generally look for
SEBI's disclosure framework for mutual funds typically pushes schemes to be more transparent about:
- The concentration of holdings in illiquid or thinly traded stocks
- Stress-test results showing how long it would take to liquidate a meaningful portion of the portfolio in adverse conditions
- Portfolio turnover and exposure limits specific to small-cap mandates
What investors should do
If you hold or are considering a small-cap fund, it's worth looking beyond past returns to a few practical questions:
- How concentrated is the portfolio in its largest holdings?
- Does the fund publish stress-test or liquidity disclosures, and what do they show?
- How has the fund behaved during past periods of market stress?
The takeaway
Better disclosure doesn't change a fund's underlying risk, but it does make it easier to compare funds on liquidity rather than returns alone. Small-cap funds can be a reasonable part of a long-term portfolio, but they deserve a closer look at concentration and liquidity than a large-cap or index fund typically does.
