Why liquidity matters
Let us understand why the liquidity of a fund portfolio is important. Liquidity refers to how easily shares can be bought or sold in the market without significant loss of value. Unlike large-cap funds, the fund manager of mid- or small-cap funds has to deal with the liquidity position of their portfolio. This is because apart from a few names, most shares Do not enjoy healthy in this section Business volume at all times. When times are good, these fill up with fluidity. But when the tide turns, liquidity can dry up fast. “During tough market conditions, liquidity dries up most quickly in these sectors. As uncertainty continues, expect liquidity to remain a challenge,” says Atanu Agarwal, Co-Founder, Upside AI.
If a fund has too many illiquid stocks in its portfolio, it can hurt its return profile. Funds that hold stocks low on the quality ladder are particularly susceptible to liquidity. Finding buyers for such shares becomes difficult and the bid-ask spread widens, thereby increasing the impact cost. It is the mark up seen while buying or selling the desired quantity of stock with reference to its ideal price. A fund holding a major portion of its portfolio in such stocks becomes vulnerable.
The performance of the fund starts deteriorating. The fund’s actual realizable NAV is reduced by its computed NAV. If faced with large redemptions, fund managers find it difficult to liquidate a portion of the portfolio quickly. They are forced to sell what they can afford (high quality liquid stocks) and not what they ideally want (low quality liquid stocks). Low quality funds will have a big impact on returns if the market declines further. This is why investors need to keep an eye on the liquidity risk in mid- and small-cap funds.
a flawed evaluation tool
To be sure, there is already an instrument in place that captures the liquidity risk in all equity funds. It comes in the form of Riskometer – a framework that specifically alerts investors to the deteriorating risk profile in any fund. “The tool captures and scores each equity fund on three parameters – market capitalization, volatility and impact cost,” says Anoop Bansal, Chief Business Officer, Scripbox. Each individual security held in the portfolio is assigned a value based on these measures.
After aggregating the risk values, the fund is assigned an overall risk level ranging from low to very high. Now the Impact Cost Value directly captures the liquidity risk in the fund. The riskometer arrives at the impact cost score based on a weighted average of the impact cost values of each security (up to 1 in the case of average monthly impact cost; 7 for between 1 and 2; and 9 for 2 above). So if the fund has many stocks with poor liquidity (higher impact cost), it will translate into a higher liquidity score (the lower the better). Now, only the final risk grade is obtained and communicated to the investors on a monthly basis. This is to give timely alerts.
Hence one can expect that the riskometer is well placed to alert the investors about any deterioration in the liquidity profile. But this is not so. As it stands, the riskometer points to the highest level of risk for all equity funds. Gaurav Rastogi, CEO, Kuvera, explains, “Most of these funds are rated from high to very high, hence liquidity risk is already under rating in times of extreme market stress.” Even pure large-cap funds—housing safe, highly liquid stocks—are assigned a risk grade of ‘very high’. Mid- and small-cap funds, which carry a lot of risk, get similar grades. Even within these categories, the scoring mechanism is unable to differentiate between different risk profiles. For now, the impact cost of stocks in the mid- and small-cap universe has remained within comfortable levels, with few exceptions.
Hence the liquidity risk is benign for most funds in this sector. But if some trigger triggers a major sell-off, the impact cost will quickly begin to mount and reflect in higher liquidity scores for some funds. But given the ceiling in the final risk grade, it would not be able to mark any downside. Nor does it allow investors to monitor risk scores for each parameter separately. “The riskometer only indicates the total risk grade and will not mark a change in any one parameter,” says Bansal. Investors should monitor the liquidity profile of the fund on their own and should not rely solely on the riskometer.