India Small-Cap Funds Sell Faster as Liquidity Improves

That matters because small-cap funds are vulnerable to a double hit when markets turn: investors pull money out, and fund managers must sell thinly traded stocks to raise cash. If sales happen into a falling market, the price impact can drag down the fund’s net asset value and punish remaining investors, even if the underlying companies have not changed.

The improved numbers come despite a sharp increase in the money being managed. Small-cap fund assets rose to ₹4.61 trillion from ₹3.54 trillion between January and September, while the trailing price-to-earnings ratio of the Nifty Smallcap 250 index climbed to 33 times from 29 times. Normally, bigger asset pools would make liquidation slower, not faster.

Instead, rising trading activity has offset some of that pressure. The average daily traded value of Nifty Smallcap 250 stocks on the National Stock Exchange increased about 21% to ₹25,440 crore in April-September from ₹20,980 crore in the prior six months, making it easier for funds to sell shares within the assumptions used in the stress test.

The disclosures, which began after Sebi and then-chair Madhabi Puri Buch flagged frothy pockets in the segment, are based on a common method: funds exclude the least-liquid 20% of their portfolios, assume they can sell no more than 10% of a stock’s daily volume and model volume rising to three times normal levels. That means the figures are not forecasts, but a standardized gauge of how exposed a portfolio may be if redemptions spike.

For investors, the takeaway is not that small-cap funds are safe, but that the plumbing has improved. Panic selling can still overwhelm liquidity quickly if volumes dry up in a fall, especially in concentrated portfolios. Fund houses can also face higher buying costs during inflows, which is why several have capped or restricted lump-sum subscriptions in the past.

The broader market backdrop also argues for caution. Small caps remain more volatile than large caps, and their liquidity can disappear quickly when risk appetite fades. That leaves long-term investors better positioned than short-horizon buyers if the cycle turns.