Small-cap funds often attract significant investor interest in the Indian mutual fund industry. The primary reason is their high growth potential. Many investors believe that small companies can grow into large businesses over time, potentially generating superior returns.
However, the possibility of higher returns also comes with higher risk. Recent studies suggest that small-cap funds have not delivered significantly higher returns than large-cap funds over the long term, despite experiencing substantially greater volatility. This raises an important question: is the additional risk truly worth the extra return?
Let us understand the performance, risks, and role of small-cap funds in long-term investing, and whether they can be the right choice for investors.
What’s Happening?
Small-cap funds primarily invest in companies with relatively low market capitalisation. While these companies have the potential to grow rapidly, they also face greater business uncertainty.
According to the CRISIL Mutual Fund Scorecard, the Nifty Smallcap 250 Total Return Index delivered an annual return of 12.54% over the past 20 years, compared with 11.72% for the Nifty 100 Total Return Index. In other words, the additional return generated by small-caps over two decades was only 0.82 percentage points.
At the same time, the level of risk was considerably higher. The annual volatility of the small-cap index stood at 28.81%, compared with 21.06% for the large-cap index. This means investors had to endure significantly greater fluctuations in pursuit of relatively modest additional returns.
Market cycles also play a major role in small-cap performance. Small-caps performed exceptionally well during the bull market between 2014 and 2017 but struggled during the period from 2018 to 2020. This highlights why small-cap investments should not be evaluated solely on the basis of recent returns.
The Risk-Reward Paradox of Small-Cap Investing
According to the report, the performance of small-cap investments is heavily influenced by market cycles. During the 2014–17 bull run, small-caps outperformed large-caps by as much as 20.52% on a three-year rolling basis. However, during the market correction between 2018 and 2020, they underperformed by up to 17.16%.
Moreover, the annual volatility of small-caps was 28.81%, compared with 21.06% for large-caps. This means investors were exposed to substantially higher risk and volatility for relatively limited additional returns. This is why the report describes small-cap investing as a ‘risk-reward paradox’, where the extra return generated does not always adequately compensate investors for the additional risk they assume.
Role of Small-Caps in Long-Term SIPs
According to the ET Wealth-CRISIL SIP Study 2026, risk reduces significantly for investors who stay invested through SIPs over the long term. The study found that the probability of loss in 10-year SIP investments was almost negligible.
Small-cap funds showed the highest probability of generating returns above 20%. However, outcomes can vary considerably over shorter investment horizons. For example, during a two-year SIP period, nearly 26% of diversified equity funds failed to generate positive returns for investors.
As the investment horizon increases, the likelihood of earning better returns also improves. After four years, the probability of generating returns above 10% rises beyond 80%, while over a 10-year period it reaches nearly 99%.
What Does This Mean for Investors?
Small-cap funds can offer the potential for higher long-term returns, but they require patience, discipline, and a higher tolerance for risk.
Investors should avoid making decisions based solely on past performance. Factors such as fund quality, valuations, portfolio composition, and the fund manager’s track record should also be carefully evaluated.
Investing through SIPs is generally considered a more effective way to gain exposure to small-caps. According to the study, the probability of earning returns above 10% rises beyond 80% after four years and reaches nearly 99% over a 10-year period. This highlights an important principle of equity investing: time in the market often matters more than timing the market.
What’s Next?
According to the report, successful small-cap investing requires more than simply staying invested for the long term. Investors must also pay attention to valuations and market cycles. The study advocates a ‘tactical approach’, where investment decisions are guided by relative valuations and prevailing market conditions.
Following the recent correction, valuations of many small-cap stocks have become more reasonable than before. This could create opportunities for selective investors. However, the performance of small-caps will continue to depend on broader market trends and economic conditions.
Therefore, instead of chasing returns in haste, investors may be better served by following a disciplined and well-thought-out investment strategy.
Disclaimer: This article is for educational and informational purposes only and does not constitute investment advice or a recommendation to buy or sell any securities. The companies mentioned are cited as examples within the context of market developments. Investors are advised to conduct their own due diligence and consult their financial advisor before making any investment decisions.
Investments in the securities market are subject to market risks. Read all related documents carefully before investing.
