Why investors need to be cautious after run-up in small-cap funds

Smallcap funds have gained 14.3 per cent this year, compared with 5 per cent for midcap funds and 5.6 per cent for largecap funds. Improving earnings have helped the category recover. Can the rally continue at current valuations? Investors should weigh the earnings outlook against the risk of a correction.

Drivers of the rally

Smallcap stocks suffered two years of price and time erosion as earnings growth fell below 10 per cent. They recovered from their March 2026 lows. A low base, resilient demand, currency depreciation and lower-cost inventory helped earnings improve in the June 2026 quarter.

“Earnings for the segment are currently expected to grow at a compound annual rate of 16–18 per cent for the next two years,” says Atul Bhole, fund manager, Kotak Mutual Fund.

Bhole says that companies must deliver the expected earnings growth to sustain the rally. De-escalation of the US-Iran war and lower oil prices could also lift sentiment.

Longer-term growth opportunities

Healthcare and diagnostics may offer long-term growth because of gaps in India’s healthcare ecosystem and favourable demographic trends over the next 10–15 years. “Precision manufacturing is another area, with companies expanding into components for global aerospace, defence and semiconductor players,” says Bhole.

Electronics manufacturing and exports may also benefit from global supply-chain shifts, cost advantages and government policies. “Technology, defence, hospitality, and manufacturing offer opportunities for good earnings,” says Ankit Patel, co-founder and partner, Arunasset Investment Services.

Pockets turning expensive

The National Stock Exchange (NSE) Nifty Smallcap 250 index trades at 32.2 times earnings over the preceding 12 months. The Nifty Midcap 150 trades at 31.8 times and the Nifty 50 at 21.1 times. Smallcap earnings grew 28 per cent year-on-year in the first quarter of financial year 2026–27 (FY27), against 16 per cent for largecaps. Estimated two-year forward compound annual growth rate (CAGR) in earnings is 20 per cent for smallcaps and 13 per cent for largecaps.

“The valuation premium for small caps appears to an extent justified,” says Chirag Mehta, chief investment officer (CIO), Quantum Asset Management Company (AMC).

Some pockets trade at elevated valuations. “Capital goods, industrials and contract development and manufacturing organisation (CDMO) look stretched. Overall, while smallcap aggregates and certain sectors appear expensive, opportunities remain in companies with strong growth and reasonable valuations,” says Mehta.

Key risks after the rally

Geopolitical tensions, oil prices and global bond yields pose risks. Small companies’ earnings can fluctuate more because of their size and sensitivity to external shocks. If earnings disappoint, investor flows weaken or the broader market corrects, smallcaps could fall more sharply than largecaps and midcaps. “Historically, they tend to correct more sharply than large caps during crises or periods of heightened risk aversion,” says Mehta.

Check fund liquidity

Smallcap mutual funds’ assets under management (AUM) have risen nearly tenfold, from about ₹45,000 crore in March 2020 to ₹4.6 lakh crore by September 2026. Strong inflows can sometimes lead to suboptimal allocations and dilute portfolio quality.

Several underlying smallcap stocks have relatively low trading depth. “Investors should assess a fund’s liquidity profile and portfolio allocation,” says Mehta.

What existing investors should do

Investors should check whether the rally has pushed their smallcap allocation above its target. “If the allocation has drifted, rebalance existing holdings,” says Akshat Garg, head of research and product, Choice Wealth.

Investors should avoid stopping their systematic investment plans (SIPs) solely because prices have risen. “Stopping an SIP turns cost-averaging discipline into a market-timing call that retail investors rarely win,” says Garg.

Investors should also consider how soon they will need the money. Those who could not stay invested during the flat market of 2025 should reduce their smallcap allocation. They should avoid raising SIP contributions merely because recent returns look attractive.

Should new investors enter?

Smallcap funds may suit investors whose goals are at least seven years away, who already have a largecap or flexicap core, and who can withstand a 25–30 per cent fall without redeeming. Investors who need liquidity soon should avoid the category.

New investors can begin through SIPs or a systematic transfer plan (STP) over nine to twelve months from a liquid or ultra-short fund. A lump-sum investment at current levels would concentrate the entry on one date without sufficient risk-reward justification.

“Within an equity portfolio, conservative investors could allocate 0–5 per cent, moderate 10–15 per cent and aggressive 20–25 per cent to small-cap funds,” says Garg.

The writer is a Delhi-based independent journalist