Small cap mutual funds have lost up to 5% and on an average these funds lost 1.42% in the last three months, an analysis by ETMutualFunds showed. Experts recommend not to worry about this short-term performance as this was driven by external factors and as valuations have become relatively fair investors should use this as a buying opportunity.
“Investors do not need to worry about short-term performance as it was driven by external factors, however, looking at their current valuations following the recent correction, valuations in the small-cap segment have become relatively fair, with a negative froth of -5.4%. This moderation makes the category more reasonably priced,” Hrishikesh Palve, Director, Anand Rathi Wealth Limited shared with ETMutualFunds.
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Palve adds that investors should consider this as a buying opportunity as it offers an attractive entry point for long-term investments while short-term performance may continue to be influenced by external factors such as global uncertainties and liquidity trends, the long-term trajectory to be driven by underlying corporate earnings growth and valuations.
On the other hand, another expert says that this dip doesn’t point either way as small caps are known for their volatility and what happens next likely depends on earnings, sentiment, and how global risk appetite plays out.
“It doesn’t clearly point either way. Small caps are known for their volatility – this kind of 3–5% move isn’t out of character. What makes it interesting is that prices have come off a bit, but the segment as a whole isn’t cheap. The Nifty Smallcap 250 is still trading at premium valuations, so this isn’t a case of panic selling. Instead, it looks more like a reality check. For anyone tracking this space, it’s not about the index – it’s about the details,” Chakravarthy V., Cofounder & Executive Director, Prime Wealth Finserv Pvt. Ltd. told ETMutualFunds.
“Quality, liquidity, and balance sheet strength seem to matter more right now than broad momentum. What happens next likely depends on earnings, sentiment, and how global risk appetite plays out,” Chakravarthy added.
Around 31 small cap mutual funds have marked their presence in the said time period, of which 24 gave negative returns whereas seven yielded positive gains.
Tata Small Cap Fund lost the most of around 4.94% in the last three months, followed by DSP Small Cap Fund which lost 4.24% in the same period. Nippon India Small Cap Fund, the largest small cap fund based on assets, lost 1.91% in the mentioned period and Invesco India Smallcap Fund was the last one to deliver a negative return of around 0.12%.
TRUSTMF Small Cap Fund offered the highest return of 3.74% and Sundaram Small Cap Fund gave the lowest positive return of 0.02% in the similar period.
Commenting on this recent dip, experts say that this fall is a part of broader market underperformance largely driven by global headwinds.
“The fall in small caps is part of the broader market underperformance, largely driven by global headwinds such as trade tensions, geopolitical escalations, and tightening global liquidity. Moreover, looking at historical data for the Small Cap 250 over the past 25 years shows an average maximum drawdown of -24.9% and a median decline of -21.16%, against this, the recent 3.5% correction is negligible,” Hrishikesh Palve said.
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Chakravarthy says that the recent 3% decline in small-cap funds reflects a broader shift in investor behaviour since SEBI’s 2024 stress-test rules and with clearer data available on liquidity and exit timelines, both investors and fund houses have turned more cautious.
The 3% decline in small-cap funds may seem modest, but it reflects a deeper shift in investor sentiment. Since SEBI’s 2024 stress-test rules, both investors and fund houses have turned cautious, aware of liquidity risks in small-cap portfolios. Valuations remain steep, with the Nifty Smallcap 250 trading around 31 times earnings, leaving little margin for error. As a result, even minor global or domestic triggers now spark sharper reactions, while earlier inflow restrictions have kept buying interest subdued during market dips,” Chakravarthy said.
In March 2024, market regulator Sebi asked mutual funds to release reports of stress tests conducted on their small and midcap schemes amid concerns over retail investors over exuberance leading to bubble formation in pockets of the market. The report card is an evaluation of liquidity and other risk ratio parameters in case the equity markets fall and investors rush to redeem their investments.
What is stress test all about?
According to Sebi, in the context of froth that was building up in mid and small cap segments and continuous inflows in small and mid cap mutual fund schemes in the last year, mutual fund houses were asked to frame a policy which contains appropriate and proactive measures to protect investors.
The policy should include but not limited to moderating inflows, portfolio rebalancing, etc. and to take steps to ensure that investors are protected from the first mover advantage of redeeming investors.
In the last three months Nifty Smallcap 100 – TRI and Nifty Smallcap 250 – TRI lost around 2.07% and 2.66%, respectively.
With this recent dip, should investors continue their SIPs and should one increase exposure to small caps or move to other market cap oriented funds?
The expert from Prime Wealth Finserv recommends that no action is needed just because of a dip, any shifts in allocation probably make more sense when linked to overall portfolio drift rather than market mood.
“What’s happening with small caps right now doesn’t really challenge the role of SIPs. If anything, it reflects why the SIP route exists – to spread out entry during the ups and downs. A short-term dip isn’t unusual here. Interestingly, SIP flows across India actually hit a fresh record in September, suggesting that investors broadly haven’t pulled back. At the same time, small-cap valuations are still on the higher side, and liquidity isn’t something to ignore – SEBI’s stress-test rules make that very clear,” Chakravarthy mentioned.
Another expert recommends going with a market cap mix of 55:25:20 across large, mid & small caps, as this will give stability, liquidity & growth in the portfolio.
“Investors can continue their SIP with strategic allocation across the categories with a market cap mix of 55:25:20 across large, mid & small caps, as this will give stability, liquidity & growth in the portfolio. Rather than timing the market, a disciplined SIP with this diversified allocation smooths out market fluctuations and positions the portfolio for consistent long-term wealth creation,” Palve recommends.
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Data from ValueResearch shows that in the last five years, small cap funds gave an average return of 27.67% whereas in the last 10 years, it gave an average return of 16.67%. In the last three years, the average return was 20.90% by the small cap funds.
After seeing the long term performance by the small cap funds, what long term strategy should investors follow to benefit from small cap opportunities without taking the excessive risk?
Palve recommends that investors should adopt a strategically diversified approach, spreading investments across market-cap segments, large, mid, small, and investment styles value, contra, and focused as this ensures broad sector and market exposure, reducing the concentration risk tied to any single category, sector, or market-cap segment, while still capturing the growth potential of small-caps.
“Looking ahead, a strong recovery in the broader market is expected, supported by improving corporate earnings in H2FY26. Mid-caps are projected to deliver 16% earnings growth, while small-caps are expected to post around 10% growth in the coming quarters, highlighting strong upside potential in these segments,” he further adds.
Chakravarthy believes that a lot of investors seem to be approaching small caps with more structure now but one common approach is to keep them as a smaller piece of the equity puzzle – say 5-15% – and then rebalance if that weight drifts too far in either direction which naturally leads to trimming after rallies and adding after dips, without relying on timing.
“Systematic investing (like SIPs or STPs) also tends to stay popular here, simply because small caps are prone to sharp swings. Some people are also favouring funds or indices that filter for quality – those with stronger balance sheets or better liquidity. And there’s a clear pattern of using large or flexi-cap exposure as the portfolio core, with small caps layered in more selectively,” Chakravarthy added.
One should always consider risk appetite, investment horizon, and goals before making any investment decisions.
(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)
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