Small-cap index at 8-month low: Take staggered, long-term fund exposure

Keep allocation measured and aligned to your risk appetite, given the segment's higher risk

The BSE Smallcap index has slipped to an eight-month low, bringing the high-risk, high-reward nature of small-cap investing back into focus. Small-cap funds have come under pressure amid geopolitical uncertainty, tariff-related concerns, softer earnings growth, and weaker risk appetite. 

Key factors weighing on small caps 

Small caps have struggled primarily because earnings have failed to justify the expectations built into prices. “Based on Q1 and Q2FY26 results and current estimates, profit growth for the small-cap universe in calendar year 2025 is likely to be around 11-12 per cent – modest for a segment that was trading near 40 times earnings,” says Ankit Patel, cofounder and partner, Arunasset Investment Services. 

A key drag has been weak nominal GDP growth, estimated at 9-10 per cent due to low inflation. “Since tax collections, government spending and corporate profits move with nominal GDP, subdued inflation has capped profit growth,” adds Patel.

 

Smaller companies, in particular, have limited pricing power, which has weighed on margins. Geopolitical uncertainty has further dampened investor risk appetite.

 

Potential triggers for a turnaround

 

Two levers could shift sentiment: Reflation and liquidity. In 2025, the Reserve Bank of India (RBI) cut the repo rate from 6.50 per cent to 5.25 per cent between February and December. It also injected durable liquidity – estimated by ICRA at around ₹9.5 trillion since January 2025 — along with a 100 basis-point cash reserve ratio (CRR) cut that could release another ₹2.5 trillion.

 

“If policy support helps push inflation back towards the 4-5 per cent range, nominal GDP growth and earnings breadth should improve, creating a more supportive backdrop,” says Patel.

 

A potential US trade deal could also improve sentiment. Valuations are now broadly in line with long-term averages.

 

What should investors do?

 

Experts advise existing investors not to panic-sell after the correction. With valuations easing from last year’s highs, new investors may consider entering small-cap funds.

 

“The segment tends to remain volatile, so this should not be seen as a ‘now or never’ opportunity. Avoid lump-sum investing. Enter gradually through staggered investments to benefit from lower valuations and reduce timing risk,” says Akshat Garg, head of research and product, Choice Wealth.

 

Some fund houses have begun reopening schemes for lump-sum investments – a signal that fund managers are finding more opportunities in the segment.

 

“Investors should avoid chasing returns and keep allocations measured and disciplined,” says Santosh Joseph, founder and chief executive officer, Germinate Investor Services.

 

Volatile category with liquidity risk

 

New investors must remain mindful of the risks. Smallcap companies are highly sensitive to changes in liquidity, interest rates, and economic conditions. Limited earnings visibility means even small disappointments can trigger sharp price moves.

 

“Liquidity risk can make exits difficult during periods of market stress. Corporate governance standards also remain uneven across the segment,” says Garg.

 

Precautions for new investors

 

A short-term approach is ill-suited for small-cap funds. A disciplined rupee-cost averaging strategy through systematic investment plans (SIPs) or systematic transfer plans (STPs) tends to work better.

 

“Investors should exercise restraint in exposure. Strong performance does not justify over-allocation, just as periods of underperformance are not a reason to stop investing altogether,” says Joseph.

 

Time horizon and allocation guide

 

Smallcaps are best suited for long-term goals. “A seven- to 10-year horizon typically delivers better outcomes, while five years is the minimum for meaningful value creation,” says Joseph.

 

Allocation should be aligned to the risk profile. “Low-risk investors may limit smallcap exposure to 0-10 per cent of their equity portfolio, medium-risk investors to 10-20 per cent, and high-risk investors to 20-30 per cent. Even for aggressive investors, excessive exposure can significantly increase volatility,” says Garg. 

The writer is a Delhi-based independent journalist.