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Necessary Evil Or White Elephant?
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Take for instance, Sundaram Small-Cap Fund: its holding of nearly 3.13 lakh shares of Watco India, a pool design and water treatment firm, amounts to about Rs 36.17 crore, and 12.41 per cent of its portfolio. That's the standard level for the share of illiquid stocks in a fund portfolio, ranging between 12-15 per cent.
But should investors baulk at illiquidity? Not necessarily. Many small-cap stocks are usually bought for the long term, and fund managers like them because the absolute returns can be huge, and make the fund's performance look better, which explains why fund managers are comfortable making these investments.
Granted, the performance of most mutual funds is most often measured relative to a benchmark index, the so-called beta return. But funds with a significant amount of money under management will, because of their size, earn lower returns; for them the alpha return of these potential ‘multi-baggers' is an attraction.
"The definition of liquidity is different for different funds," says Alpesh Shah, partner and director, Boston Consulting Group in Mumbai. "Illiquid stock can be part of a very liquid portfolio, and yet be illiquid in the stock market." As he points out, investing in these stocks is approved by the investment committee of the asset management company, or AMC.
The problem for investors in mutual funds could be that in tough times, selling those stocks is that much harder, and might actually pull down the net asset value (NAV) of the fund. "That's why we should take a risk-adjusted return view of fund performance and communicate that to investors," says Vikaas Sachdeva, chief executive officer, Edelweiss Mutual Fund.
Though close-ended funds are a miniscule part of the AUM of the industry, they were among the funds that carried a significant amount of illiquid stocks, simply because they require less active management, keeping transaction costs and management expenses down, leaving potentially more for the investor.
How do funds manage these stocks? Among the larger funds, they are closely tracked, and if the potential returns are not commensurate with strategy, funds will get out of these stocks, and take a small loss if they have to. But a cross-section of fund managers acknowledged that they do not talk about it to the public.
They get out of it in stages; selling illiquid stock at one go can be difficult. Or else they could grit their teeth and hold it. Paraphrasing Albert Einstein, fund managers keep things simple, but not simpler.
(This story was published in Businessworld Issue Dated 30-04-2012)