A small cap fund holds 40 stocks equally, with a median daily traded value of Rs 8 crore. Its rule is to be able to exit any holding in 10 days at 20% of volume. What is its capacity, and what should it do at Rs 800 crore?

The headline capacity is Rs 640 crore, 40 names at Rs 16 crore each on the median volume, but the least liquid names set the real limit, and at equal weights that is only Rs 240 crore. At Rs 800 crore each position is Rs 20 crore, which 27 of the 40 names cannot meet. The fund should stop taking lump sums, move to weights set by liquidity, which hold about Rs 795 crore, and replace the least liquid names.

Turn the rule into rupees. Selling at 20% of a Rs 8 crore daily volume means Rs 1.6 crore a day, and ten days of that is Rs 16 crore, the most the fund can hold in the median name. The rule exists because a fund that owns more than it can sell in a fortnight turns a wave of redemptions into a fire sale, with the remaining investors paying the price impact. A shop that stocks more than it can sell before the season ends has the same problem.

Rs 640 crore assumes all forty stocks trade like the median one. They do not. In an equal-weight fund every position is the same size, so the position the fund can hold is set by its least liquid stock: Rs 3 crore a day allows Rs 6 crore, and forty positions of Rs 6 crore is a capacity of Rs 240 crore. Even at Rs 640 crore, 17 names would already be over their limits. The average hides the tail, and the rule is about the tail.

Each position is Rs 20 crore. 27 of the 40 holdings allow less than that, and the least liquid would take 33 trading days to sell at 20% of volume, more than six weeks. In a bad month, redemptions would be met by selling the liquid names first, leaving the remaining investors with a portfolio even more concentrated in the illiquid ones. That is how small cap funds get into trouble: not from one bad stock, but from a liquidity mismatch built quietly by inflows.

Four steps, in order. First, stop the problem growing: pause lump sum inflows while keeping regular instalments, which is how Indian small cap funds have usually managed it. Second, size positions by liquidity, not equally: each name up to its own ten-day limit and no name above 5%, which supports about Rs 795 crore. Third, replace the least liquid names over time with similar businesses that trade more, trimming where prices allow rather than dumping. Fourth, report the liquidity position to the board every month, including days to sell a quarter and half of the portfolio; Indian small cap funds now publish liquidity stress tests under an industry framework, so confirm its current format. Say the limit: daily volume itself falls in a sell-off, so a ten-day rule measured in calm markets is optimistic.