Smallcap funds generate alpha despite uncertainty in equity markets

Most active equity schemes managed to outperform benchmarks over the past year amid heightened volatility

Despite recurring turbulence in the equity market, the majority of actively-managed equity schemes across key categories managed to generate excess returns over their benchmarks in the past one year, offering some relief to investors. 

Among the major categories, smallcap funds — which also account for the highest number of investment accounts — emerged as the strongest performers relative to their benchmarks. According to data compiled from Value Research, 24 out of 30 schemes outperformed the Nifty Smallcap 250 Total Return Index (TRI) over the one-year period. Flexicap funds too recorded a healthy degree of outperformance. Data showed that 28 out of 40 flexicap schemes beat the Nifty 500 TRI in the one-year period ended May 22. 

The outperformance ratio was even stronger over longer timeframes, with 26 out of 35 schemes outperforming over a three-year period. Largecap funds, however, delivered a relatively muted performance compared to broader market cat­e­gories, with only about half the schemes outperforming in the one-year period. Midcap funds also posted a lower outperformance ratio of around 57 per cent. 

Experts said the comparatively better performance of active schemes — especially in the smallcap space — was driven by improved market breadth and greater stock-picking opportunities amid heightened volatility. 

“Smallcaps remain a segment where stock selection plays a significant role, and fund managers with focused portfolios and high conviction positions have been able to generate meaningful alpha over benchmark indices,” said Feroze Azeez, Joint CEO, Anand Rathi Wealth. 

Nilesh Naik, head of PhonePe Mutual Funds, attributed the outperformance to the recovery in quality smallcap stocks following a sharp correction. 

“Smallcap funds saw a significant correction around a year back. In the last quarter of FY25, the Nifty Small Cap 250 TRI was down almost 15 per cent, whereas the Nifty 50 TRI remained more or less flat. During such corrections, even quality stocks with strong fundamentals tend to decline, yet they typically bounce back as conditions normalise,” he said. 

“While smallcap stocks remained volatile over the past year, they have seen a point-to-point recovery. Consequently, many active smallcap funds focusing on relatively stronger fundamentals have been able to outperform their benchmark,” he added. 

The availability of a wider investment universe has also aided alpha generation in the smallcap segment. “Active smallcap funds are not constrained to the 250-stock index and can exploit a much wider universe (including largecap and midcap names), which has helped them ride both the breadth expansion and pockets of largecap strength. Sector-specific alpha in infra, pharma/healthcare, and some banking/financial-services pockets has also contributed to the outperformance of selected schemes,” said Ankur Punj, MD & business head at Equirus Wealth. 

Largecap schemes, meanwhile, faced a rela­tively more challenging backdrop amid weakness in heavyweight sectors such as banking and information technology (IT). 

“Largecap funds, on the other hand, have faced a relatively more challenging environment because sectors like banking and IT, which carry significant weight within largecap indices, have seen phases of underperformance over the past year,” said Azeez. According to Punj, apart from sector-specific weakness, largecap fund managers also face structural limitations that make alpha generation more difficult. 

“Largecap funds typically hold 3 to 5 per cent cash, avoid high concentration, and are constrained in picking non-largecap names, which cuts their ability to generate alpha when the market is very top-heavy,” said Punj. “Largecap IT, certain banks, and some consumer-durables names have underperformed the broader index, which has dragged down many largecap schemes that are overweight these segments,” he added.

 

Naik also attributed the relatively weaker performance of some largecap schemes to higher exposure to the IT sector. 

“For the funds that have underperformed the benchmark, relatively higher exposure to the IT sector has been one of the key reasons,” he said.