Don’t get shocked that Retail Participation and Behavioural Patterns

Small-cap mutual funds have gone through a volatile ride, with many witnessing massive outflows, according to industry voices like Mr. Naren.  Does the current phase of the market completely discount allocation in a small-cap fund?  Should you avoid still while allocating in small-cap Funds?

The small-cap mutual fund category, long considered a fertile ground for high-growth investment, has once again proven to be both an opportunity and a cautionary tale for investors. The correction that began in late September 2024 was significant and swift. Small-cap funds saw a sharp 22% decline, more pronounced than in mid-cap (20%), multi-cap (19%) and large-cap (17%) categories.  The correction that began in late September 2024 was significant and swift. Small-cap funds saw a sharp 22% decline, more pronounced than in mid-cap (20%), multi-cap (19%) and large-cap (17%) categories.

 Over the past nine months, small-cap funds have undergone a dramatic cycle of decline and recovery, offering critical insights into their risk-return profile, investor behaviour, and fund management strategies. This period, stretching from September 2024 to June 2025, has served as a live case study in market dynamics, valuation sensitivity, portfolio construction, and the psychology of retail investing.

Nifty Smallcap 250 bottoming out on February 28, 2025. The revival was driven by several converging factors: attractive valuations post-correction, strong GDP growth data, and renewed flows from domestic institutional investors. The price-to-earnings (PE) multiple compression, from 32 in September 2024 to 26 in March 2025, signalled value, prompting investor re-entry.

Small-cap funds bounced back stronger than their larger peers, delivering 22% returns between March and June 2025, ahead of mid-cap (21%), flexi-cap (16%), and large-cap (15%) categories. Sectoral indices such as Nifty India Defence, Nifty Capital Markets, and BSE Capital Goods staged dramatic rallies, with returns ranging from 29% to over 70%.

Don’t get shocked that Retail Participation and Behavioural Patterns

The number of small-cap folios grew by 29 lakh to touch 2.5 crore between September 2024 and May 2025. This increase was partly driven by recency bias—investors attracted by recent high returns despite underlying risks. However, the inflow of ₹36,372 crore during this period underscored confidence in India’s growth story and the perceived long-term potential of small-caps. In fact, advisors might be late, but clients have become more aggressive in the last 9 months while investing in the category. The current war situation of Iran and Israel, and all other geopolitical hiccups, provides an opportunity for investing in the category for the long-term wealth creation.

Key Takeaways for Investors and Advisors

1. Valuations are not just academic—they are the primary determinant of forward returns. Buying into euphoric markets can lead to steep drawdowns.
2. Small-cap investing requires patience and a risk appetite. Investors must brace for sharp corrections and should avoid overexposure.
3. Diversification is a double-edged sword—while it mitigates downside, it can also erode outperformance if overdone.
4. Fund selection matters—schemes with a disciplined investment approach, a focus on quality, and prudent risk management outperformed peers.

The last nine months have been a powerful reminder that small-cap funds, while rewarding over the long term, are inherently volatile. The correction tested investor patience, and the recovery rewarded conviction. For investors and advisors alike, the key lies in understanding the nature of the asset class, maintaining a long-term view, and aligning allocations with both goals and risk capacity.