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The exposure of the stock within the fund is taken as the weight to arrive at the final score.

Source: CRISIL Two 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.

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.

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.

Liquidity position of small-cap funds has deteriorated sharply 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.

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. 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.

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.

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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.

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