Stay invested in quality smallcap funds, if risk profile and horizon allow

Investment is risky but medium-term outlook for companies in certain sectors is favourable

Smallcap funds remain preferred bets for high-risk takers due to their promise of outsized returns. Despite market volatility, these funds garnered net inflows of Rs 4,092 crore in March 2025, taking total inflows in FY25 to Rs 41,673 crore, according to monthly data from the Association of Mutual Funds in India (Amfi). Smallcap schemes have declined 15.7 per cent over six months: the steepest among diversified equity categories.

 

“The outlook for smallcap funds remains cautiously optimistic despite recent market turbulence. While these funds have faced declines due to heightened volatility, their medium-term prospects appear favourable, particularly in sectors like health care, manufacturing, and emerging industries,” says Harish Bihani, executive vice-president and fund manager, Kotak Mutual Fund.

 

Large universe

 

Smallcap funds must invest at least 65 per cent in stocks of companies beyond the top 250 by market cap. “There are only 250 large and midcap stocks, whereas there are more than 4,000 smallcap stocks. If one can pick companies which grow rapidly and profitably over a long period, one can potentially outperform broader indices,” says Sandeep Bagla, chief executive officer, TRUST Mutual Fund.

 

Riding economic momentum

 

Long-term investors in smallcap stocks can see their money compound at a higher rate in an expanding economy. “India being a higher growth market, smallcap companies are expected to grow faster than larger companies, and enjoy higher valuations in anticipation of growth,” says Bagla.

 

Being under-researched, smallcap stocks have greater potential to generate alpha.

 

More volatile

 

Smallcap stocks carry risks such as a lack of management and financial depth to fund sustainable growth. “Smallcap stocks are inherently more volatile, with sharper price swings compared to largecaps. Liquidity constraints can also pose challenges, making it harder to exit positions during a downturn or when one is wrong,” says Bihani.

 

Their ability to withstand global uncertainties is less.

 

Focus on track record

 

Due diligence is critical when investing in smallcap funds. “Prioritise funds that hold companies with strong management teams, healthy balance sheets, and sustainable growth prospects. Financial metrics such as low debt, consistent cash flows, and improving profitability are critical indicators of resilience,” says Bihani.

 

Bagla emphasises the need to consider the track record and experience of the fund management team.

 

Suitable for aggressive investors

 

Investors with high risk tolerance may go for these funds. “Volatility-averse investors or those with short-term financial goals should avoid them as the potential for sharp downturns can disrupt the objective of capital preservation,” says Bihani.

 

Existing investors may continue with their allocations in high-quality funds. “Existing investors should stay invested if their original thesis remains intact and the portfolio quality is strong, avoiding knee-jerk reactions to short-term volatility. New investors can consider a gradual entry, starting with a modest allocation and increasing exposure over time as they gain comfort with the inherent uncertainties and ongoing global volatility,” says Bihani.

 

A long-term horizon of five to seven years is a must. Allocation should align with the investor's risk profile. “Smallcap funds should typically constitute a smaller portion of an equity portfolio — around 5-10 per cent for moderate investors and up to 15-20 per cent for those with higher tolerance for volatility,” says Bihani.

 

Combining smallcap funds with largecap or flexicap funds can provide a balanced equity allocation, reducing overall portfolio risk while maintaining growth potential. Systematic investment plans can help average out purchase costs over time.

 

                                                             Stay invested to enjoy high returns                                                                                                                                        Returns (%) 

Smallcap fund	6-month	1-year	3-year	5-year	10-year
Nippon India	-16.6	5.4	20.5	40.2	20.7
Quant	-16.4	-3.4	19.1	49.0	19.5
SBI	-15.5	4.2	15.5	31.2	19.0
Axis	-11.9	10.4	17.0	32.2	18.3
HSBC	-20.2	1.7	17.2	36.4	18.2
Kotak	-18.0	6.3	13.4	35.7	17.6
HDFC	-15.1	-0.3	18.4	35.7	17.4

*Above one-year returns are compound annualised   Source: Navigation RA