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Retail investors chasing outsized returns in small-cap stocks were facing a liquidity squeeze even before the US-Israel-Iran war-led energy shock roiled markets, as mutual funds faced longer timelines to liquidate holdings.

Data from the Association of Mutual Funds of India (Amfi) showed that, as of 1 February, the time required to liquidate 50% of portfolios in leading small-cap schemes has risen sharply over the past year, reflecting thinning volumes and weaker market depth.

The largest fund in the category, Nippon India Small Cap Fund, required 44 days—up 13 days from a year ago—to sell half its portfolio if faced with redemption pressure. The Quant Small Cap Fund saw the steepest increase, with liquidation time rising by 31 days to 87 days, while the HDFC Small Cap Fund and the SBI Small Cap Fund took 71 and 66 days, up 9 and 4 days, respectively.

This is when the benchmark BSE Smallcap 250 Index has declined only moderately—6.2% in January, compared with a 10.3% fall in January 2025—suggesting the underlying stress is more structural: lower participation and waning risk appetite are making exits harder, particularly in a downtrend when small caps tend to underperform broader markets.

The BSE Sensex declined 3.5% in January, compared with a 1% fall in the same month last year.

Exchange data showed India’s overall market capitalization shrank by ₹21.35 trillion from an all-time high of ₹482 trillion at the start of January. A year ago, market value had declined by ₹18.48 trillion to ₹425 trillion amid concerns over the impact of US President Donald Trump's tariffs on global trade.

"The overall market cap tells a story of how small-cap investors have borne greater pain than other cohorts even before the West Asia war began,” said G. Chokkalingam, founder at equity research and advisory firm Equinomics Research Pvt. Ltd.

In small caps, even modest inflows can push stock prices sharply higher, while small outflows can trigger disproportionately deeper declines compared with mid- and large-cap stocks, according to S. K. Joshi, consultant at financial services firm Khambatta Securities.

Even though small-cap funds continued to attract the highest inflows, drawing ₹55,263 crore between February 2025 and February 2026, compared with ₹53,119 crore for mid-caps and ₹28,664 crore for large-cap funds, according to Amfi data, the rising liquidation timelines leave the segment highly vulnerable.

Should redemption pressures intensify, funds may struggle to find buyers without triggering sharper price corrections.

Another factor driving the rise in liquidation timelines is the surge in assets under management (AUM) of small-cap funds over the past year, despite market corrections.

As fund sizes expand while portfolios remain largely unchanged, higher exposure to the same stocks has reduced liquidity, increasing the time required for exits, said Chandraprakash Padiyar, senior fund manager at Tata Asset Management.

For instance, the Nippon India Small Cap Fund saw its assets rise by ₹16,792 crore between 1 February 2025 and 1 February 2026. For HDFC, SBI, and Quant's small-cap funds, assets have increased by ₹8,948 crore, ₹6,802 crore, and ₹4,820 crore, respectively, according to Amfi data.

If the segment sees further correction, liquidity could tighten further, extending the time required to liquidate positions.

Feroze Azeez, joint chief executive at wealth management firm Anand Rathi Wealth Ltd, said the modelled time required to exit positions tends to increase with small-cap volumes moderating. If markets were to weaken further due to geopolitical uncertainties, this effect could become more pronounced as risk appetite and participation decline.

An analysis of monthly trading volumes showed that nearly 55% of stocks in the Nifty Smallcap 250 Index have seen lower average volumes in February than their average over the last three months, Azeez added.

“It is possible that the liquidation timelines may increase if the markets correct further; the key question will be if there is a redemption pressure,” said Juzer Gabajiwala, director at trading platform Ventura Securities Ltd.

Even though the number of days to liquidate a portfolio may rise, it is unlikely that people will rush to liquidate 50% of a mutual fund scheme's portfolio. For the Nippon India Small Cap Fund, 50% of the portfolio would imply an outflow of ₹34,000 crore, which is unlikely, according to experts.

“There have been consistent net inflows into small-cap funds, and even if outflows occur, they are likely to be gradual unless there is an extreme scenario like oil spiking sharply or major geopolitical shocks,” said Gabajiwala.

Besides, there is an in-built liquidity buffer of around 14-15% at any given time to manage redemptions, said Sirshendu Basu, head of products at Bandhan Mutual Fund. “If you look at the small-cap category, liquidity like cash plus large-cap holdings was around 15% in February 2025. Currently, it is slightly lower at about 14%."

The higher liquidation days indicated by stress tests do not point to any immediate concern, particularly when portfolios are supported by balanced asset allocation across market capitalizations, said Azeez.

In fact, the current market correction has narrowed the valuation gap between the BSE Smallcap Index and the Sensex to 14.5% from 25% historically, prompting some market analysts, such as Dhiraj Sachdev, chief investment officer at portfolio management services provider Roha Venture, to suggest that small-cap stocks with sound fundamentals appear attractive.

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