Mutual fund investment: What changing flows in small-cap funds are telling investors

Small-cap mutual funds continue to attract investors with a higher appetite for risk, drawn by the promise of outsized long-term returns. However, market experts caution that the segment demands patience, discipline, and a long investment horizon, as volatility in small-cap investing remains structurally higher than in large-cap strategies.

Overall equity mutual fund inflows moderated in January 2026, declining to ₹24,029 crore—around 14 per cent lower than the ₹28,054 crore recorded in December 2025 -- signalling a slowdown in fresh allocations amid heightened market volatility.

Within this broader trend, small-cap funds witnessed a sharp moderation in net inflows, which fell to ₹2,942 crore in January from ₹3,824 crore in December 2025. Investor participation in the segment has been uneven over recent months. Net inflows were marginal in November, October, September, and August 2025 — ranging between ₹3 crore and ₹5 crore — highlighting cautious and selective allocation behaviour in the small-cap space.

Small caps remain a growth engine

At a category level, small-cap funds remain positioned for growth acceleration, but their risk profile is materially different from that of large-cap funds. Volatility in the small-cap category is currently estimated at around 33 per cent annually, nearly three times the roughly 12 per cent volatility seen in large-cap funds.

This elevated volatility is structural rather than cyclical, driven by lower stock liquidity, wider earnings dispersion, and heightened sensitivity to macroeconomic and liquidity cycles. As a result, small-cap funds are better suited as a satellite allocation within diversified equity portfolios rather than as a core holding.

Regulatory norms further shape the risk-return dynamics of the category. Under SEBI regulations, small-cap funds must invest a minimum of 65 per cent of assets in companies ranked 251st and beyond by market capitalisation. While this ensures classification purity, it also amplifies dispersion in returns across fund managers. Over a five-year period, category returns have ranged between 28 per cent and 34 per cent, underscoring both the segment’s growth potential and the importance of fund selection.

Performance trends and flows

Performance leadership within the category remains mixed across time frames. Funds such as Quant Small Cap, Bandhan Small Cap, Nippon India Small Cap, HDFC Small Cap, and Invesco India Smallcap have featured prominently, but differences in portfolio construction, expense ratios, and assets under management point to divergent risk-return profiles rather than uniform category performance.

Flow data reflects strong but selective investor interest. Bandhan Small Cap Fund emerged as the clear leader in one-month net inflows, attracting over ₹1,050 crore, signalling strong investor conviction in its strategy. Meanwhile, Mirae Asset Small Cap recorded the highest percentage growth in inflows, indicating momentum-driven allocations rather than indiscriminate category-wide buying. This trend suggests that investors are becoming increasingly discerning in their small-cap exposure.

Favoured stocks and sector shifts

Stock-level positioning reinforces this selective approach. The Multi Commodity Exchange of India (MCX) has emerged as the most accumulated stock, having been added by 19 out of 34 small-cap funds, reflecting broad-based conviction. In contrast, Oil & Natural Gas Corporation (ONGC) saw notable reductions, particularly by the Quant Small Cap Fund, pointing to a moderation in energy exposure.

Sector trends over the past six months show a clear rotation toward Financial Services, where assets under management rose by over 20 per cent. Technology and Utilities also witnessed incremental overweight positions. Meanwhile, allocations to Basic Materials, Industrials, and Energy declined, reflecting caution amid valuation concerns and cyclical uncertainties.

What investors should know

For investors considering fresh allocations, valuations and liquidity remain critical factors. A recent study by Abakkus Mutual Fund noted that nearly half of small-cap stocks are trading well below their historical peaks, potentially creating opportunities for calibrated, long-term investments. However, investors should review stress-test disclosures published by fund houses to assess downside risks and portfolio liquidity.

Experts recommend a staggered approach, preferably through systematic investment plans (SIPs), to manage volatility. Long-term data remains supportive: since September 2016, SIP investments in the Nifty Smallcap 250 index have delivered a CAGR of about 17 per cent, compared with 12 per cent for the Nifty 50. Still, prudent allocation and patience remain essential, as small-cap investing rewards discipline far more than short-term timing.