Small-cap funds face a higher liquidity risk, show latest stress test

Small-cap mutual funds in India face higher liquidity risk due to the lower trading volumes and thinner market depth of small-cap stocks, making it challenging for fund managers to quickly buy or sell large positions. Recent SEBI and AMFI stress tests have highlighted that several small-cap funds would require significantly more time to liquidate their portfolios during market stress, increasing potential risks for investors. To address these concerns, SEBI has directed mutual funds to enhance transparency, conduct regular liquidity stress tests, and moderate inflows, especially as small-cap fund assets under management (AUM) have surged sharply in recent years. Fund houses are also adopting strategies like holding some large-cap stocks and maintaining higher cash levels to cushion against redemption pressures and protect investor interests.