Small-cap Stock Funds May Offer Limited Return on Elevated Risk: Study Finds

Small-cap Mutual Funds Fail to Deliver Premium Returns Over Long-Term

A recent report by Share.Market by PhonePe has challenged the conventional wisdom that small-cap mutual funds necessarily generate superior long-term returns. The analysis, which spanned 20 years of historical data, compared the performance of the Nifty Small Cap 250 Total Return Index (TRI) with the Nifty 100 TRI.

According to the report, the Nifty Small Cap 250 TRI generated an annualised return of 12.54 percent as of March 2026, outpacing the Nifty 100 TRI's 11.72 percent annualised return. However, the excess return was limited to a modest 0.82 percentage points. Despite the higher returns, small-cap funds exposed investors to significantly greater volatility and deeper drawdowns.

The report highlighted the highly cyclical nature of small-cap performance, which tends to thrive in bullish phases and struggle during market corrections. During the 2014-17 bull run, small caps outperformed large caps by around 20.52 percent over rolling three-year periods. Conversely, during the 2018-20 correction, they underperformed by as much as 17.16 percent.

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The findings raise questions about the effectiveness of a simple buy-and-hold strategy in the small-cap segment. Historical data pointed to a strong negative correlation between past three-year outperformance and future three-year outperformance relative to large caps, indicating that periods of strong gains were often followed by weaker relative returns and vice versa.

The report favours a "tactical approach based on relative valuations", arguing that market cycles and valuation levels play an important role in determining outcomes for investors in the segment. Small-cap stocks have seen extended periods of correction, narrowing the performance gap between small- and large-cap companies. With valuations returning to more reasonable levels compared with earlier peaks, the report suggests that the current environment could offer opportunities for tactical allocations to the segment over the next 12 to 18 months.

For investors looking to navigate the volatile small-cap landscape, the report stresses the importance of rigorous fund selection. It recommends focusing on funds that have demonstrated "performance consistency" relative to peers and investment approaches with a bias towards "quality and value" factors.

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Recent data from the Association of Mutual Funds in India (AMFI) shows that small-cap funds have continued to attract investor interest. Combined inflows into large-cap, mid-cap, and small-cap funds rose to Rs 15,324.93 crore in March, up from Rs 9,995.73 crore in February and Rs 8,132.56 crore in January. Small-cap funds attracted the highest inflows in each of the three months, climbing from Rs 2,942.11 crore in January to Rs 3,881.06 crore in February and Rs 6,263.56 crore in March.