The small-cap mutual fund segment has demonstrated resilience amid market turbulence, with nearly 90% of funds outperforming the BSE SmallCap index despite facing significant headwinds. While the broader index declined sharply by 21% since December 2024, active fund management has proven its worth by cushioning investor losses, though no fund managed to deliver positive returns during this period.

Fund Performance Analysis

The performance data reveals a clear distinction between top-performing and underperforming funds within the small-cap category:

Several funds faced more severe corrections, with JM Small Cap Fund, Kotak Small Cap Fund, Tata Small Cap Fund, HSBC Small Cap Fund, and LIC MF Small Cap Fund posting losses between 15%-20%.

Valuation Metrics Remain Elevated

Despite the sharp correction, valuation concerns persist across the small-cap segment. The BSE SmallCap index currently trades at a P/E ratio of 24.06, while individual fund portfolios show varying valuation levels:

PGIM India Small Cap Fund trades at an elevated P/E of 61.81, reflecting the varied valuation landscape within the category.

Expert Perspectives on Market Outlook

Tejas Sheth, Fund Manager at Axis Mutual Fund, emphasizes the inherent nature of small-cap investments as high-risk, high-return products. He notes that small-cap funds typically generate 200-300 basis points more than mid-cap funds over the long term, with historical returns averaging 18%-20% CAGR. The 2020-2024 phase saw outsized gains due to strong GDP growth, but markets are now normalizing toward historical averages.

Sachin Jain, Managing Partner at Scripbox, advocates for disciplined asset allocation, preferring large caps for most investors. He suggests that small- and mid-cap allocation should be limited to aggressive investors and assessed individually, recommending staggered SIPs or STPs over lump sum investments for those with a five to seven-year investment horizon.

Investment Strategy Recommendations

Shweta Rajani from Anand Rathi Wealth maintains a positive long-term outlook for small caps, noting that the segment is currently in a repricing phase. She highlights that small caps typically undergo mean reversion for 3-5 years after delivering strong performance, with historical drawdowns of 20-25% from peak levels being normal. Recovery periods usually begin within 18-24 months of such corrections.

Rajani points out that valuations have corrected meaningfully and are now trading at a negative froth of around -12.80%, suggesting the segment is approaching attractive valuation levels for long-term investors. Financial advisors continue emphasizing the importance of discipline and proper asset allocation, particularly as many investors chase past returns rather than following structured investment plans.

Mid-cap and small-cap mutual fund schemes achieved unprecedented inflows in 2025, defying challenging market conditions and demonstrating sustained investor confidence in these segments. According to AMFI data, mid-cap schemes received ₹49,939.00 crore during the year, representing a substantial 46.00% increase from the previous year, while small-cap schemes attracted ₹52,321.00 crore, marking a robust 53.00% growth.

Market Performance and Challenges

Despite the record inflows, market performance presented a mixed picture throughout 2025. The underlying indices showed divergent trends, with broader market volatility creating challenging conditions for investors.

Market breadth remained particularly weak across both segments. In the BSE MidCap index, 86 out of 140 stocks ended the year with negative returns, while the BSE SmallCap index saw 871 of its 1,186 constituent stocks finishing in the red. This contrasted sharply with the BSE100 index, where 61 stocks posted gains against 39 recording losses.

Investment Flow Dynamics

Rajesh Palviya from Axis Securities attributed the strong inflows to steady SIP investments and investors' continued additions to their mutual fund holdings. This behavior was supported by the strong three-year and five-year outperformance of mid-cap and small-cap stocks over large-cap shares. Domestic investors emerged as the primary drivers of these inflows, having been the main source of net flows over the past two years.

Foreign investors largely remained absent from these segments, instead focusing on selling large-cap stocks. This behavior further concentrated domestic flows into mid-cap and small-cap schemes, creating a distinct investment pattern in the Indian mutual fund landscape.

Market Share and Total Equity Flows

The significance of mid-cap and small-cap schemes in the overall equity mutual fund ecosystem grew substantially during 2025. Both categories achieved notable increases in their share of total equity inflows.

Total equity inflows for 2025 stood at ₹3.51 lakh crore, representing an 11.19% decline from ₹3.94 lakh crore in 2024, though significantly higher than ₹1.62 lakh crore recorded in 2023.

Investor Behavior and Outlook

Analysts noted that the absence of significant outflows despite nearly 16 months of muted returns indicates sustained investor commitment to these segments. Many investors maintain a three- to four-year investment horizon, even as near-term returns have been disappointing.

Independent research analyst Ambreesh Baliga highlighted that mid-cap and small-cap funds have delivered superior results compared to individual portfolios. While many individual portfolios declined by 20.00% to 30.00% or more, even the worst-performing mid-cap and small-cap funds were down only about 5.00% to 6.00% as of the end of December.

Palviya observed that investors have been strategically using market declines to average their investments, with SIP inflows into mid-cap and small-cap schemes continuing on a regular basis. This disciplined approach has helped maintain steady flows despite market volatility and challenging conditions throughout 2025.