The mutual fund landscape beyond the top 500 stocks, in terms of their holdings as a percentage of market volumes of these stocks, has surged, surpassing the highs seen in 2018, according to a report by Elara Securities.
Although the curve peaked in August 2022, there has been another spike since June 2023, primarily fueled by inflows into small-cap investments. This surge in holdings beyond the top 500 stocks presents a challenge in securing exit liquidity. Historically, liquidity tends to diminish sharply during market corrections, creating a cycle of decreased liquidity that impacts smaller counters significantly.
The current pace of inflows into small-cap funds has pushed fund managers to explore less explored stocks, akin to previous market movements observed from 2004 to 2007 and from 2014 to 2018. This recent surge, marking the third round since 2020, intensified notably from April 2023.
This increased interest in smaller stocks heightens liquidity risks when market sentiment changes. While cash levels in large-cap and mid-cap schemes remain steady, small-cap fund managers notably increased cash levels in October 2023 due to a significant portion of the inflow remaining unutilized. However, continued outperformance in the small-cap index could lead to further compelled deployment, similar to what was witnessed from May to August 2023.
The absolute cash in small-cap schemes has expanded from Rs 13,000 crore in September 2023 to Rs 15,800 crore, reflecting a lack of conviction at current market levels.
Despite an October sell-off, small-cap schemes continued to outperform large-cap schemes, benefiting from strong liquidity support. However, the pace of outperformance momentum has slowed down, though small-cap folios continue to grow. In October, the rate of new folio additions slightly decreased compared to the preceding months between June and September, signaling a marginal slowdown in the pace of expansion.
(With Agency Inputs)