Smallcap fund correction: Trim exposure if it exceeds 20%, avoid full exit

Smallcap funds have declined 21.6 per cent over the past three months. Many investors, who were highly bullish on this segment during the bull run of 2023 and 2024, are a shaken lot today. They must adopt the mantras of asset allocation and long-term investing to weather this phase.

 

Volatility may continue in short term

 

The inflated valuations of smallcap stocks are getting corrected. “After Covid, small and midcap companies experienced faster growth than large caps, leading to significant rerating. The decline over the past six months reflects a reversal of this rerating,” says Shreyas Devalkar, head-equity, Axis Mutual Fund.

 

The global climate is also contributing to volatility. “We are amid tremendous global uncertainty, which has the potential to reshape global trade. Markets are likely to remain volatile until investors are able to figure out the ‘new normal’,” says Shiv Chanani, senior fund manager-equity, Baroda BNP Paribas Mutual Fund.

 

A few other factors have also played a part. “Aggressive foreign institutional investor (FII) selling and moderate quarterly earnings from Indian companies have also contributed. We expect the next quarter to remain volatile,” says Nehal Mota, co-founder and chief executive officer (CEO), Finnovate.

 

Earnings-related uncertainty continues to weigh on small caps. “Though valuations have eased, uncertainty around earnings growth persists. These stocks are not yet significantly undervalued,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

 

Long-term outlook remains positive

 

Despite short-term headwinds, experts remain optimistic about the smallcap category. “As India moves from being the world’s fifth-largest economy to the third-largest, the smallcap space will continue to provide tremendous opportunities for wealth creation,” says Chanani.

 

Government initiatives like the production-linked incentive (PLI) scheme and support for micro, small and medium enterprises (MSMEs) are strengthening Indian manufacturing and services. “These measures will enhance the growth potential of smallcap companies,” says Mota.

 

Technology and financial firms, key segments within small caps, are set to grow rapidly. “Increased digital adoption, fintech expansion, and a robust financial ecosystem position these sectors for growth,” adds Mota.

 

The small and midcap space offers exposure to niche sectors not available in large caps. “Their smaller size and promoter-driven nature also provide the potential for faster growth,” says Devalkar.

 

Chanani anticipates a turnaround as global trade stabilises and earnings improve. “We expect earnings growth to accelerate from the first half of FY26, when the base becomes favourable,” he says.

 

The Reserve Bank of India’s (RBI) monetary policy could also provide support. “Injection of ample liquidity and initiation of rate cuts will help smaller firms,” says Dhawan.

 

Overexposure to one segment is risky

 

One takeaway from recent market movements is the importance of factoring in volatility alongside returns. “High beta funds rise faster than the market during uptrends but fall more during downturns,” says Abhishek Kumar, Securities and Exchange Board of India (Sebi)-registered investment adviser and founder, SahajMoney.com.

 

This cycle has reinforced the need for portfolio diversification and avoiding excessive exposure to any single segment.

 

Existing investors: Pare exposure if overweight

 

Investors should review their smallcap allocation. “Even with a long horizon, smallcap exposure should be limited to 10-20 per cent of the equity portfolio,” says Dhawan.

 

Exiting entirely may not be wise. “Investors with long-term goals should hold on to their positions. Only those with short-term financial needs should exit,” says Kumar.

 

Remaining invested during downturns and continuing with systematic investment plans (SIPs) has paid off historically. “Historical data show that whenever the market has fallen by more than 20 per cent, the average compounded annual growth rate over the next seven years plus has been around 20 per cent,” says Mota.

 

New investors: Get accustomed to volatility first

 

First-time equity investors should avoid smallcap funds. “They should stick to largecap, flexi-cap, or index funds (based on largecap indices),” says Dhawan.

 

Once they adapt to market volatility, they may consider small caps. “They must enter these funds with at least a seven-year horizon,” says Kumar.    Despite correction, smallcaps are not yet undervalued 

12-month forward PE		Average			12-month forward PB	Average
Index	Current	5 Year	10 Year		Current	5 Year	10 Year
Nifty 50	18.3	19.4	20.4		2.8	2.9	2.6
Nifty Midcap 150	27.5	26.7	18.8		4.2	3.4	3.1
NSE NIFTY Smallcap 250	20.7	18.8	20.0		2.9	2.6	2.3

 

Trailing 12-month PE		Average			Trailing 12-month PB	Average
Index	Current	5 Year	10 Year		Current	5 Year	10 Year
Nifty 50	21.0	23.9	26.6		3.3	3.3	3.5
Nifty Midcap 150	33.1	37.3	40.1		4.6	3.7	3.4
NSE NIFTY Smallcap 250	24.4	29.3	48.1		3.3	3.0	2.9

 

PE stands for price-to-earnings ratio. PB stands for price to book value

Data as on March 18,2025.

Source: Bloomberg

Compiled by BS Research Bureau