Smallcaps stage strong comeback, outperform Nifty 50 - expert explains what’s driving the surge

India’s small-cap funds are roaring back into the spotlight, driven by a visible shift in investor sentiment and an appetite for higher risk, despite their reputation for volatility. Once overlooked in favour of large-cap stability, smallcaps are proving to be the stars of the recent market rally, significantly outperforming benchmark indices and attracting renewed interest from investors seeking long-term growth.

Over the past month, while the Nifty 50 posted a modest gain of 2.6%, the Nifty Smallcap 100 surged an impressive 14.7%, signaling robust momentum in the lower tiers of market capitalization. This rally reflects easing volatility and growing confidence in India’s economic prospects, prompting investors to open their portfolios to more aggressive bets.

“In January 2025, discussions around small-cap investments and their potential for long-term growth gained prominence,” said B Padmanaban, Certified Financial Planner (CFP). “A comparative analysis of the returns on small-cap investments versus the widely favored large-cap investments from the prior year reveals intriguing insights. The crucial lesson is the importance of diligently evaluating the data and deriving conclusions based on practical experiences rather than purely theoretical assumptions. Actively participating in the market is vital for understanding the nuances of these investment options.”

The positive sentiment is visible in mutual fund performance as well. Small-cap funds delivered an average return of around 8.20% in May. Out of 30 funds in the category, the DSP Small Cap Fund emerged as the top performer with a return of approximately 14.05%, followed by the Quantum Small Cap Fund, which delivered 11.06%. Meanwhile, the SBI Small Cap Fund posted the lowest return in the segment at about 5.88%.

Market experts note that while large-cap benchmarks have remained largely range-bound, the real momentum has been building at the bottom of the market cap pyramid. Smallcaps are now shaping up as compelling opportunities for investors aiming to construct a robust long-term portfolio.

The underlying fundamentals of small-cap companies are also contributing to their growing appeal. As the Q4 earnings season concludes, data reveals that 74% of the top 250 small-cap companies reported a Return on Capital Employed (ROCE) in double digits during FY25—a clear indicator of strong operational efficiency and sound business models.

From a valuation perspective, the segment appears ripe with opportunities. Many small-cap stocks continue to trade below their historical valuations, particularly in niche sectors, providing investors the chance to accumulate quality names at attractive prices.

The long-term investment case for smallcaps remains robust. Over the past seven years, the segment has delivered an impressive compounded annual growth rate (CAGR) of 27.6%, outpacing other market segments. Additionally, smallcaps offer exposure to a diverse range of sectors, including BFSI, healthcare, FMCG, and power, allowing investors to tap into varied pockets of growth.

Sectoral tailwinds further support the small-cap narrative. The recent interest rate cut by the Reserve Bank of India is expected to benefit smaller Non-Banking Financial Companies (NBFCs) and tier-2 and tier-3 banks, which typically rely more heavily on wholesale funding and stand to gain from lower borrowing costs.

For investors considering the small-cap segment, long-term mutual fund performance data adds significant perspective. Several small-cap funds have delivered stellar returns over the past decade, reflecting both fund manager expertise and the segment’s potential for wealth creation. Among the top performers:

Fund Name                                                      10-Year CAGR (%)
Nippon India Small Cap Fund – Direct Plan    22.79%
Quant Small Cap Fund – Direct Plan              20.26%
Axis Small Cap Fund – Direct Plan                 20.22%
SBI Small Cap Fund – Direct Plan                  20.18%
HDFC Small Cap Fund – Direct Plan              19.51%

Source: Value Research

Nippon India Small Cap Fund leads the pack with a 10-year CAGR of 22.79%, attributed to its focus on identifying high-growth potential companies with strong fundamentals. Quant Small Cap Fund, with a return of 20.26%, leverages a data-driven, quantitative model for stock selection. Close behind, Axis Small Cap Fund has delivered 20.22%, emphasizing risk management and diversification. The SBI Small Cap Fund, delivering 20.18%, uses a bottom-up approach focusing on strong management and solid financial health. Meanwhile, HDFC Small Cap Fund, with a 19.51% return, targets niche market leaders with significant growth potential.

Despite their inherent volatility, smallcaps are increasingly being recognized as a strategic component of diversified portfolios. However, experts advise caution, emphasizing thorough research and a long-term investment horizon to navigate the risks associated with this high-reward segment.

“Investors should look beyond theoretical models and engage directly with the market to truly understand small-cap dynamics,” Padmanaban advised. “Practical learning and experience are essential in exploring the diverse landscape of investment opportunities that smallcaps present.”