Small-cap funds see better score on liquidity stress-test. What does it mean?

Small-cap mutual funds now need less time to sell their holdings in a stress scenario, even as the money they manage has grown by about 30% this year. As of September, the average small-cap fund would take 11.9 days to sell half its portfolio, down from 18.8 days in January. That is according to stress-test data that fund houses disclose for mid- and small-cap funds through the Association of Mutual Funds in India (Amfi). The time needed to sell a quarter of the portfolio has fallen to 6.2 days from 9.6 days.

These disclosures began in March 2024. Money had poured into small- and mid-cap funds through 2023, and valuations in the segment had risen sharply. Madhabi Puri Buch, who was chairperson of the Securities and Exchange Board of India (Sebi) at the time, had also flagged ‘pockets of froth’ in small- and mid-cap stocks. Fund houses began publishing stress-test results, first every fortnight and later every month.

When investors redeem, the fund must pay them within a few working days, and to raise that cash, it must sell stocks. Many small-cap stocks trade in small volumes, so selling a large holding quickly can push its price down. In a market fall, when many investors redeem at the same time, such forced selling pulls down the fund’s net asset value (NAV). The loss is borne by investors who stay on in the fund.

The stress test shows how long this selling would take. The fewer the days, the easier it is for the fund to raise cash. The drop from 18.8 days to 11.9 days means the average small-cap fund is now better placed to handle a rush of redemptions, which lowers the risk of investments taking an extra hit in a sell-off.

Volume spike

Liquidity is a problem even when money comes in. In a thinly traded stock, a large buy order quickly consumes the shares on offer at the current price, so the fund ends up paying more for each subsequent lot. This is impact cost in reverse: the fund’s own buying pushes the price up. When heavy inflows need to be deployed quickly, they can artificially push up valuations. This is why several fund houses have, at different times, stopped or capped lump-sum investments in their small-cap funds, allowing only systematic investment plans (SIPs), often within limits.

Small-cap fund assets rose to ₹4.61 trillion from ₹3.54 trillion between January and September. More money usually means bigger positions to sell, which should stretch liquidation time rather than shorten it. Valuations also rose, with the trailing 12-month price-to-earnings (PE) ratio of the Nifty Smallcap 250 index going up to 33x from 29x. Most of the fall in liquidation time came between January and June, when the average dropped to 11.4 days. It has stayed broadly at that level since.

Higher trading activity in small-cap stocks is a key reason. The average daily traded value of Nifty Smallcap 250 stocks on the National Stock Exchange (NSE) rose about 21% to ₹25,440 crore in April–September 2026, from ₹20,980 crore in the previous six months.

This matters because the stress test is based on trading volumes. Under Amfi’s method, a fund excludes the least-liquid 20% of its portfolio and sells the remainder in proportion. It can sell no more than 10% of a stock’s daily trading volume, and the test assumes volume rises to three times normal levels. When stocks trade more, the same holding can be sold faster, so the estimated time falls.

What experts caution

“For small-cap funds with concentrated exposures, selling in bad markets can be tough when liquidity is thin. Large sell orders in thinly traded stocks push prices down further, adding to impact costs,” pointed out Deepak Jasani, an independent market expert.

“Investors should come into small-cap funds with a long time horizon so as to make the arithmetic of liquidation time irrelevant for their investments,” said Joydeep Sen, a corporate trainer (financial markets) and author.

Fund houses have to pay redemption proceeds within three working days, even in a falling market. What changes is the price investors get. The fund pays out at that day’s NAV, and if it has to sell stocks in a hurry to raise cash, those sales can pull the NAV down.

This is where the two risks of small-cap stocks come together. The first is volatility. Small-cap stocks tend to rise faster in good times and fall harder in bad times, which drives the high returns that attract many investors to these funds. The second is liquidity. Many of these stocks trade in small volumes, and in a sell-off, buyers step back just as sellers rush in. With few buyers around, large sell orders can push prices down further, adding to impact costs. Funds whose holdings are concentrated in fewer stocks can get hit harder.

The two risks can also feed each other. When the market falls, investors with a short horizon tend to redeem in panic. Funds then have to sell stocks to pay them, at a time when there are few buyers. That pushes prices and NAVs lower, which can trigger more redemptions. Those who exit in panic lock in their losses. Those who stay bear the cost of the forced selling.

Investors still need a long-term horizon

The stress test shows how exposed a fund is to such a cycle. A lower number is better, but it is only an estimate based on recent trading, and trading can dry up quickly in a fall.

Investors should use stress-test data as an indication of a fund’s ability to liquidate the portfolio in an extreme market scenario. When it comes to investing in small-cap funds, investors must remember that this segment of the market tends to be more volatile; hence, only those with a higher risk appetite and a longer investment horizon should consider it.

• Small-cap funds could sell half their holdings in 11.9 days, versus 18.8.
• Busier trading in small-cap stocks is a key reason that selling looks quicker.
• It is only an estimate; trading can vanish quickly in a fall.
• Panic redemptions force funds to sell stocks, hurting investors who stay invested.
• Only investors with a high-risk appetite and long horizons should pick small caps.