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Liquidity an important parameter for selection of midcap mutual funds

Apr 17, 2017 / Dwaipayan Bose | 182 Downloaded | 10685 Viewed | |
Liquidity an important parameter for selection of midcap mutual funds }
Picture courtesy - PIXABAY

Indian equities have performed very strongly in the last one year with the frontline indices, Sensex and Nifty advancing by 18 – 19%. The performance of the broader market, represented by the BSE – 500 and Nifty – 500 indices was even better, with nearly 25% returns in the last one year. The mid and small cap market segments were the strongest performers with BSE – Midcap and BSE – Small Cap indices rising by 33% and 37% respectively. Small and midcap equity mutual funds registered very strong performance in the last 12 months (average category returns were more than 30%) outperforming large cap funds by a wide margin. The outperformance of small / midcap funds attracted investor attention and these small / midcap mutual fund schemes received large retail inflows.

Concerns related to midcap funds

While investors have good reasons to cheer the performance of small midcap funds, there are some concerns regarding these funds that, investors should be aware of. Firstly, for the last 2 years or so, several fund managers have expressed concerns about the valuation of small and midcap stocks. The conventional thought is that, midcap stocks trade at a valuation (P/E ratio) discount to large cap and that has been the actual case in the market for many years.

However, a couple of years back the situation reversed and now midcap stocks are trading at a valuation premium to large cap stocks. The Sensex is trading at a P/E ratio of 23, the BSE – 100 at 25, while the BSE Midcap Index is trading at a P/E ratio of 31; this is an unusual situation. Valuation is a complex topic with multiplicity of opinions. Whether the valuation premiums enjoyed by midcap stocks (compared to large cap) is justified or not, is outside the scope of today’s post. However, we want our readers to be aware of this concern.

The more relevant concern, especially for mutual fund investors, is the liquidity profiles of small and midcap equity funds. While we always say that, equity investments (especially in midcap and small cap) should be made over a long investment horizon; one of the biggest advantages of investing in open ended mid & small cap schemes is the liquidity. Liquidity is not a concern in large cap equity or diversified equity (large cap oriented) funds, because large cap stocks are very liquid. But liquidity should be an important consideration for midcap investments because midcap stocks are less liquid than large cap stocks, especially here in India. We will explain the reason in the next paragraphs.

Free-float shares of small midcap companies

The free-float shares of small cap and even midcap companies are quite small compared to large cap entities. Let us understand what free float shares are. Free float shares are the shares in the hands of the public investors and these shares are regularly traded in the stock exchanges. Free float shares excludes shares owned by the promoters of the company, shared awarded to company officers or shares owned by related parties of the promoters. Free float shares are less in India compared to other markets for historical reasons. Most companies are family owned businesses and the promoters (family members of the promoters) want to maintain to high ownership so that, they do not lose management control of their companies. Some families have several factions and each faction may want to ensure a sufficiently high ownership in case of dispute over management succession.

Small free float can cause several issues. It creates a demand supply mismatch, which can lead to significant price changes (up or down) on very thin volumes. The bigger issue of small free float is lack of liquidity, which should be a cause of concern for fund managers and mutual fund investors. If a midcap mutual fund scheme receives a lot of inflows from investors, the fund manager may not be able to buy the shares of the companies he likes the most, because there may not be enough supply.

The worst case scenario for a fund manager is, if there are redemptions from a scheme and the fund manager finds himself / herself in a situation where there are not enough buyers in the market for shares the fund manager wants to sell to meet the redemption requirements. In such a situation the fund manager will be forced to sell shares of companies he / she does not want to sell and this will be detrimental to the interest of the unit-holders who remain invested in the scheme. In such situations, some Asset Management Companies (AMCs) may put restrictions on redemptions, which is harmful to the investor’s interests, not to mention the reputational damage suffered by the AMC.

Liquidity crises happen in exceptional circumstances

Investors who have invested in small and midcap equity funds should not get alarmed and understand that, schemes with sufficient Assets under Management (AUM) will be able to meet your redemption request or business as usual (BAU) redemption requests of other investors, without harming the interest of investors who stay invested. Situations described in the previous paragraph are caused by large scale redemptions. Based on my experience, large scale redemptions are usually a result of panic selling, often as a reaction to some adverse news, rumours etc. These instances are very rare and seen mostly during severe bear markets (e.g. financial crisis of 2008). However, as a prudent investor, you should check the liquidity profile of your small and midcap mutual fund schemes before investing, so that you are comfortable in any circumstance.

How to know the liquidity profile of your mutual fund scheme?

A few months back, there was an article in Economic Times which suggested that, the liquidity profiles of small and midcap mutual funds in India was worsening. The ET article based its observations on CRISIL Liquidity Scores of mutual fund schemes. What is CRISIL Liquidity Score? CRISIL’s Liquidity Score is measure of how much time a mutual fund scheme will take to liquidate all the holdings of the scheme. If the Liquidity Score of a mutual fund scheme is 10, it means that the scheme will take 10 days to liquidate its entire portfolio of stocks. Needless to say, higher the Liquidity Score figure, less liquid the fund is.

The methodology of calculating Liquidity Scores of a mutual fund scheme is outside the scope of this post, but investors should note that, Liquidity Score of a scheme is a function of market conditions. Liquidity Score of the same portfolio of stocks will be lower in bull markets and higher in bear markets, because demand for stocks is low in bear markets. Instead of focusing on the Liquidity Score of a fund, retail mutual fund investors should focus the relative ranking of midcap funds based on liquidity scores. CRISIL ranks mutual schemes from 1 to 5 based on relative Liquidity Scores; 1 being the highest rank (high liquidity) and 5 being the lowest (low liquidity). You will find CRISIL rankings on their website by going to the link, https://www.crisil.com/capital-markets/crisil-mf-ranking-list.html.

How AMCs manage liquidity risk?

As discussed earlier, liquidity risk is not a significant concern for large cap or diversified equity (multi-cap) funds. However, it is a concern for small and midcap mutual fund schemes, especially once the AUM of these schemes have attained a particular size. If I was an investor in small / midcap mutual fund scheme, I would be concerned, if the scheme owned a disproportionately large percentage of free float shares of a midcap company; how (to whom?) will the fund manager sell the shares if the need arises and what will be the impact cost?

To ensure sufficient liquidity in small / midcap funds with relatively large AUMs, fund managers can buy liquid large cap stocks in the scheme portfolio to improve the portfolio liquidity. Some midcap mutual fund schemes have done that, over the past few years. The fund managers of such schemes have argued that, it has not violated the investment mandate of the scheme because the scheme was set up as a diversified equity fund. While I hear the fund manager’s arguments, my point is that, most retail investors invest in a scheme based on how the scheme is positioned (large cap, diversified or midcap) by their financial advisors or based on how the scheme is categorized by various mutual fund websites. If you have invested in such schemes with specific goals and assumptions in mind, you should take a note of the change in investment strategy and rework your assumptions accordingly.

The other way to improve or at least, stop deterioration of liquidity profile of midcap equity funds is to restrict fresh subscriptions, so that the AUM does not grow to an unmanageable size. Some mid and small cap schemes have adopted this strategy in the last one or two years. Some schemes put restrictions on lump sum investment; others stopped taking any lump sum investment while accepting Systematic Investment Plans (SIPs); while some stopped taking any fresh subscription (lump sum or SIP). In my person view, the second approach (stopping / restricting subscriptions) takes better care of the interests of existing investors compared to the first approach (investing in large caps).


Historical evidence shows that, midcap funds have outperformed large cap funds over a long investment term. My grandfather always used to tell me, “hope for the best, but prepare for the worst”; this is the one of the best pieces of wisdom that I have learnt from my elders. Investors with high risk appetite find midcap funds attractive, but you should also be aware of the risks. When investing in midcap stocks and funds, we usually think of risk in terms of high beta (volatility). Liquidity is also a risk, as far as midcaps / small caps are concerned. In this post, we discussed how portfolio liquidity can impact midcap mutual fund investors. We also discussed in this post, how you can compare different schemes based on their liquidity profiles. If you have made investments or plan to make investments in midcap funds, you should evaluate their liquidity profiles.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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