Liquidity Risks in Small-Cap Investments: A Growing Concern

In the dynamic world of investing, small-cap stocks have long been a magnet for investors seeking high returns. However, recent data from the Securities and Exchange Board of India (SEBI) reveals a troubling trend: heightened liquidity risks in the small-cap segment. This metric, crucial for stress tests mandated by SEBI, indicates that small-cap funds are facing significant challenges in liquidating their portfolios, which could impact investors’ ability to exit their positions smoothly.

According to the data, the time required to liquidate 50% of a small-cap fund portfolio has increased by 39.4 days between February 2024 and January 2025. Similarly, the time needed to liquidate 25% of a portfolio has risen by 19.8 days. This prolonged liquidation period can delay investor exits, leading to distress selling at lower prices, and impacting the net asset value of their holdings.

Funds need to be able to liquidate portfolios to meet redemptions, rebalance holdings, or manage risks. Longer liquidation times can delay investor exits, lead to distress selling at lower prices, impacting the net asset value of their holdings. If a fund’s size grows substantially, or it gets a very large percentage of assets in a short period of time, it can become very challenging for the manager to continue running the fund in the same way as before, said Kaustubh Belapurkar, director–fund research at Morningstar Investment Research India Pvt. Ltd.

Belapurkar further elaborated, They may need to either dilute the mandate by buying more stocks or start moving up the market cap curve and buying larger-cap names to manage liquidity. And that’s not ideal, because that’s not why the investor gave them the money in the first place. To counter such potential risks, many small-cap funds have adopted a ‘soft close’ strategy, restricting new inflows to existing investors or systematic investment plans (SIPs). This approach helps control the pace of inflows and better manage liquidity concerns.

Belapurkar added that while retail investors in India are spread across many small-ticket investments, which helps reduce liquidity risks, the recent market correction might stabilize small-cap investments as investors start looking for alternative opportunities.

Liquidity Risk as an Inherent Part of Small-Cap Investing

Dhirendra Kumar, founder and chief executive of Value Research, advises investors not to take the liquidity risk indicator at face value. This liquidity indicator that’s used to measure the liquidity of smaller mutual fund portfolios… it really shouldn’t be looked at as some kind of scientific document. It’s a very mechanical calculation. It just tells you how many days it would take to sell off the entire portfolio if the fund wanted to do that tomorrow, he said.

Kumar emphasized that liquidity risk is an inherent part of investing in small-cap funds. However, he noted that small-cap funds provide professional oversight, better diversification, and liquidity management compared to individual investors directly purchasing small-cap stocks. The way I see it, you get compensated for that compromise through the higher returns you can potentially earn over the long run, Kumar said, elaborating on the importance of selectivity in small-cap mutual funds. There are around 4,600 small-cap companies out there but mutual funds only invest in about 680 of them. The rest are either complete trash or outright fraudulent. So, the selectivity that mutual funds bring is where the real risk reduction happens.

Kumar also noted that small-cap funds are allowed to invest up to 40% of the portfolio in non-small cap stocks to improve overall liquidity.

Market Dynamics and Investor Behavior

Vinit Sambre, head of equities at DSP Mutual Fund, highlighted the rise in the number of days that small-cap funds would potentially need to liquidate portfolios but reassured investors that this was a dynamic metric influenced by market cycles. When compared to our past experiences during the most challenging redemption periods, we do not see a significant liquidity risk, he said.

Retail investors concerned about rising liquidity risks should focus on disciplined investing and proper diversification, said experts. Small-cap funds always carry higher risk and this has been a known fact, said Harshad Chetanwala, co-founder of MyWealthGrowth.com. Those who have been investing in these funds as a part of diversification and have restricted the allocation to 10-20% of their overall portfolio need not be worried about the current market conditions related to small caps.

However, he warned that investors with excessive exposure to small caps may be more susceptible to market swings. The key is to stick to diversification and not go overboard in small caps or even mid-caps. There are lots of investors who have stayed disciplined and even today their overall portfolio is not much impacted, Chetanwala said.

The Lure of Small-Caps and Regulatory Pressure

Abhishek Kumar, a SEBI-registered investment adviser and founder of SahajMoney, pointed to other alarming trends emerging from the SEBI stress test data. The stress tests reveal a critical liquidity crisis in India’s booming small-cap mutual funds, with top funds now requiring 50-60+ days to liquidate half their portfolios—a 9.4-day increase from 2024, he said.

Abhishek Kumar added that although mid-cap funds demonstrated significantly better liquidity efficiency, investor inflows continued to be directed toward small caps. Mid-cap alternatives show 58% better liquidity efficiency, yet investors continue flooding into small caps, he said. With cash reserves varying dramatically (3-13%) across funds managing ₹2.5 lakh crore (trillion), regulators face mounting pressure to address this dangerous mismatch between rapid growth and declining exit liquidity.

In the U.S., similar concerns have been raised about the liquidity of small-cap investments. The Securities and Exchange Commission (SEC) has been closely monitoring the liquidity of mutual funds and exchange-traded funds (ETFs) to ensure that investors can exit their positions without significant delays or price impacts. The SEC’s recent emphasis on liquidity risk management has led to stricter guidelines for fund managers, requiring them to conduct regular stress tests and maintain adequate liquidity reserves.

For instance, the SEC’s liquidity risk management program requires fund managers to classify their assets into liquidity buckets and maintain a sufficient amount of highly liquid assets to meet redemption requests. This approach helps fund managers better manage liquidity risks and ensure that investors can exit their positions smoothly.

In conclusion, while small-cap investments offer the potential for high returns, investors must be aware of the associated liquidity risks. By focusing on disciplined investing, proper diversification, and understanding the liquidity metrics, investors can better navigate the complexities of small-cap investing. As the market evolves, both regulators and investors will need to remain vigilant to address the challenges posed by liquidity risks in small-cap funds.