Mid, smallcap fund recovery may not sustain; experts urge cautious moves

New investors should enter only if they have the required investment horizon and risk appetite, not merely because these funds have rallied

Midcap funds have risen 11 per cent, while smallcap funds are up 13.5 per cent on average over the past month. Experts believe the pain in these segments has not ended entirely, and hence investors, existing and new, must proceed with caution. 

 

Rebound followed prolonged correction

 

Investors should view the bounceback as a recovery from the sharp correction these segments witnessed from late 2024. In some cases, midcap and smallcap segments corrected by around 25-35 per cent. “This correction was triggered by expensive valuations and a weakening growth outlook caused by tightening fiscal and monetary policies,” says Rupesh Patel, senior fund manager-equity investments, Nippon India Mutual Fund. 

The correction made stock prices in these segments attractive. “After the correction, investors felt valuations had reached re-entry levels,” says Arvind Rao, founder of the investment advisory firm Arvind Rao and Associates. 

Investors felt that the March correction may have been overdone. “The market correction of more than 10 per cent in March was sharper than the likely 2-4 per cent impact on (financial year 2026-27) FY27 earnings if the war impact recedes by April-end,” says Trideep Bhattacharya, president and chief investment officer-equities, Edelweiss Mutual Fund. 

Patel adds that the bounceback was driven by expectations that geopolitical issues would be resolved soon and would not hurt earnings growth. 

Domestic consumption has not crashed completely. “Goods and Services Tax (GST) collections, credit growth, and corporate earnings in a few tracked sectors suggest that domestic consumption remains intact,” says Rao. Expectations of a better earnings cycle in select domestic sectors have also supported the broader market. 

Retail investors have not quit equities despite the downturn. “Systematic investment plan (SIP) inflows have remained resilient despite the correction caused partly by the war in West Asia,” says Rao.

 

Factors that could sustain recovery  

The rally’s sustainability will depend on easing geopolitical tensions and a decline in crude oil prices. “Oil prices at around $85 per barrel and a stable rupee could support inflation, earnings, and foreign flows,” says Vishal Dhawan, founder and chief executive officer (CEO), Plan Ahead Wealth Advisors. 

Earnings growth must catch up with valuations. “Earnings in the fourth quarter (Q4)  of FY26 and the first quarter (Q1) of FY27 will be the real test for the rally,” says Rao. 

Companies with pricing power will drive the rally. “It will likely be more sustainable for companies with pricing power that can pass on commodity-driven cost increases through price increases,” says Bhattacharya. 

Continued inflows into domestic mutual funds, supported by strong systematic investment plan (SIP) and lump-sum flows, can aid broader market liquidity. Stable inflation, in line with the Reserve Bank of India’s (RBI’s) estimate, would keep interest rates at current levels and support a neutral stance.  

Continued government spending on infrastructure could benefit many midcap and smallcap companies. “Midcap and smallcap companies in sectors like roads, railways, defence, manufacturing, engineering, logistics, and components have been major beneficiaries of government capex,” says Rao.

 

Risks to the recovery 

Geopolitical uncertainty remains the key risk. “If a war-like scenario persists and crude oil prices remain above $100, the bounce could become unsustainable,” says Bhattacharya. 

Domestic inflation could then become a concern. Higher inflation could delay RBI rate cuts, which would affect smaller companies. 

“Prolonged geopolitical tensions could cloud the earnings growth outlook because of higher costs and disrupted supply chains,” says Patel. 

If earnings come under pressure, the re-rating could reverse. “Earnings downgrades could be triggered by weak demand, margin pressure, or both,” says Dhawan. Rao says margin pressure is expected in Q4FY26 and Q1FY27. 

US tariff-related risks could affect India’s manufacturing and pharmaceutical sectors. “Tariff-related disruption could squeeze the earnings of companies built around export competitiveness,” says Rao. 

If the macro environment worsens, some companies would suffer more than others. “Companies with weak business models and narrow moats could see higher-than-expected erosion in profitability and would give away their gains,” says Bhattacharya.

These segments have given poor returns to investors since the peak of September 2024. Further underperformance could hurt retail investors’ confidence. “This would affect domestic flows, which have supported markets while foreign portfolio investors (FPIs) have been net sellers,” says Dhawan. Rao adds that a weak monsoon could raise food prices and hurt consumption. 

 

Valuations no longer frothy 

Valuations have corrected from their peaks. “After market corrections, valuation froth has mostly worked itself out over the past 12–15 months,” says Bhattacharya. 

At the 2024 peaks, the midcap index traded at roughly a 40-50 per cent premium to the Nifty 50 on a price-to-earnings (P/E) basis. The long-term average premium has typically remained in the 15-25 per cent range. “Current midcap and smallcap valuations are closer to the historical average but at the upper end,” says Rao. 

Many pockets are still not cheap, so any earnings downgrade could affect these segments. “If earnings disappoint, valuations could again appear stretched,” says Rao.

 

Existing investors should rebalance 

Midcap and smallcap funds can create long-term wealth, but they tend to be more volatile. Existing investors should not rush towards the exit after the rally if they have time available. “Review your portfolio and rebalance based on your asset allocation,” says Dhawan. 

Lump-sum investments should also be avoided in anticipation of more gains. “The time to add aggressively was probably in March, not now,” says Rao.  

Money needed for goals due in one to three years should be moved out of midcap and smallcap funds and into conservative assets. 

“Investors uncomfortable with 20-30 per cent drawdowns should reduce exposure,” says Dhawan.

 

How new investors should enter 

New investors should avoid entering purely because of the recent rally. They should enter only if they have the requisite risk appetite and investment horizon.  

Lump-sum investments should be avoided. “New investors should enter through SIPs or systematic transfer plans (STPs) over 12-18 months. In smallcap funds, they can extend the investment period to 24 months,” says Dhawan. Staggered investing allows investors to average out their purchase cost and helps generate better returns over the long term. 

New investors should assess whether they have the risk tolerance to handle large drawdowns, which are common in these segments. 

Smallcap funds are particularly vulnerable. “Lower liquidity and limited analyst coverage of these stocks can lead to sharper falls of as much as 30-35 per cent in adverse market conditions,” says Rao. Investors who are panic-stricken by such falls should avoid smallcap funds.  

Allocation to these two categories should match risk appetite. “Conservative investors should allocate 5-10 per cent of their equity portfolio to midcap funds and 0-5 per cent to smallcap funds. Moderate investors should allocate 15-20 per cent and 5-10 per cent respectively to these two categories. For aggressive investors, the allocations can be 25 per cent and 15 per cent respectively,” says Dhawan.