How do fund managers maintain liquidity in their funds?
-Wadia
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There are different ways of maintaining liquidity. One, you have liquid stocks. Even the smallcap funds are not supposed to be having 100 per cent of smallcap stocks. They have the flexibility of investing 65 per cent in smallcap stocks and remaining elsewhere. So, they could be investing in liquid stocks.
The other is that every fund is allowed to have 5 to 10 per cent in cash, which can be invested in short-term debt, overnight call money or elsewhere. Nothing is in cash as such, even the cash there generates little bit of return. Also, I think in a normal situation, the funds liquidity is entirely met by the flows. Because, in an open-end fund where lot of investors are putting their money, and only some investors are taking their money out, the net outflow from the fund would be less than the inflow. For example, if there are investors who are putting Rs 500 in a fund and the money which is being pulled out by investors is Rs 400.
Fund managers have to worry about liquidity only when the outflow is more than the inflow. When you get less money and when you have to pay out more. That is when you have to worry about what to sell. For that, they have the cash or the short term debt or the liquid stocks in the portfolio. Beyond that, if there is a run on the fund, then that's a risk because when a fund manager is forced to sell their stocks at the inopportune time, those are the occasions which are not so pleasant. Because most investors come in mass only when things are very bad. When the market is crumbling and falling every other day, that is the time when the fund manager finds it difficult to sell. His selling may lead to bigger fall in the underlying stocks. It negatively impacts the NAV of the fund far more substantially.