Summary of this article
Small-cap funds had a weak year
Small-cap stocks had become too expensive, and earnings didn’t keep up
Should mutual fund investors continue to invest?
Small-cap funds, which have been topping the charts for some years now with jaw-dropping high returns, have disappointed investors with low single-digit returns in the last year. Small-cap mutual funds delivered an average return of 2.5 per cent in the last year, as of November 19, 2025, according to data from Ace Mutual Fund. Year to date, they have gone down by 3.34 per cent.
The returns have been nowhere close to what investors have experienced in recent years.
In four out of the last five calendar years, the fund performed really well, attracting a lot of new investors. In 2024, the category delivered an average return of 26.58 per cent. In 2023, it gave 41.59 per cent returns. The category delivered 62.67 per cent returns in 2021 and 31.20 per cent in 2020. The highest and lowest returns in the category for the four out of the last five years, when they had shown exceptional performance, are given in the table below. For the data, we considered only those funds which have been in existence for at least five years.
| Small Cap Funds: Toppers & Laggards of Last 5 Years | ||||
| Calendar Year | Fund with Highest Returns | Calendar Year Returns | Fund with Lowest Returns | Calendar Year Returns |
| 2020 | Quant Small Cap Fund | 74.90% | HSBC Small Cap Fund | 15.41% |
| 2021 | Quant Small Cap Fund | 88.05% | ITI Small Cap Fund-Reg | 31.97% |
| 2023 | Bandhan Small Cap Fund | 53.74% | SBI Small Cap Fund | 25.37% |
| 2024 | Bandhan Small Cap Fund | 42.77% | ICICI Pru Smallcap Fund | 15.46% |
| Source: Ace Mutual Fund |
Small Cap Funds: Reason for Poor Returns
Several factors contributed to the underperformance in the small-cap mutual funds space. At the macro level, key triggers included geopolitical tensions, reciprocal tariffs, and supply-chain uncertainties. Foreign institutional investors (FIIs) also played a role, as they significantly reduced their exposure to Indian small- and mid-cap stocks, a behaviour typical during periods of global uncertainty. This shift was further reinforced by weak corporate earnings.
On the domestic front, muted earnings growth for several consecutive quarters led to an earnings-valuation mismatch in small caps. “If you look at valuations, small caps have been overvalued,” says Chokkalingam Palaniappan of Prakala Wealth, a Chennai-based mutual fund distributor. While earnings growth slowed across the board, including mid-caps and small-caps, the stock prices did not correct accordingly, raising concerns about overvaluation, he adds.
In September, the Nifty Smallcap 250 index was trading at a price-to-earnings ratio of 32.6, which eased to 30.8 in October. Compared to its 5-year median PE of 28.9, the valuations were on average 10-15 per cent higher.
Similarly, the Nifty Midcap 150 index was trading at a PE of 32.9 in September, which inched up to 34.1 by October-end. Compared to the 5-year median PE of 30.6, the current valuations stood pricey.
Around one and a half years ago, the Securities and Exchange Board of India (SEBI) also cautioned retail investors about rising volatility and stretched valuations in mid and small-caps.
Last year, in March, the then Sebi Chairperson, Madhabi Puri Buch raised an alarm over stretched valuations of small and mid-cap stocks. She said, “There are pockets of froth in the market. Some people call it a bubble, some may call it froth. It may not be appropriate to allow that froth to keep building.”
Should Investors invest in small-cap funds?
Most investors just look at returns. They continue to pour money if the returns are up, and the money flow goes down if the returns are muted. This is evident from the data released by the Association of Mutual Funds in India (AMFI).
Now, as the returns of small-caps are down, it is expected to see some fall in the inflows into these categories, says Palaniappan. “But, if you are an investor having a high risk appetite, and your goal is far away, say 10 or 20 years away, this can be the right time to invest in mid and small caps through a systematic investment plan (SIP) mode,” he explains.
New investors, however, can skip investing in these funds during their initial years. According to Shweta Jain, founder of Investography, a Bengaluru-based wealth management firm, small-cap funds are risky for newer investors. “They can start off with large-cap funds to understand and get accustomed first,” she says.
Small caps need a longer time to reap rewards. There will be time periods, cautions Jain, when they're exceptional and times when they're doing very badly. Hence, Jain asks investors who want to invest in them to stay invested for a longer tenure.
Those who worry about the underperformance of small- and mid-cap funds must understand that the performance of market-cap funds is cyclical. A market cap fund will not always perform the best; it will go through dull periods as well, explains Chokkalingam Palaniappan of Prakala Wealth.
To sail through such short-term volatility, he suggests investors who carry the required risk appetite invest in mid and small caps through SIPs. “ Existing investors need not fear; they can continue to invest,” he adds.
