Smallcaps under pressure: Smallcaps hit 8 month low, yet fund returns show downside resilience

Small-cap stocks have come under renewed pressure, with the BSE Smallcap index sliding to an eight-month low and reflecting a broader loss of momentum across riskier segments of the equity market. A mix of geopolitical uncertainty, tariff-related risks, softer earnings visibility and subdued investor risk appetite has weighed heavily on small-cap valuations, triggering a sustained correction in the segment.

At the heart of the slowdown is an earnings–valuation mismatch. Profit growth among small-cap companies has remained modest despite stocks previously trading at elevated multiples. Slower nominal GDP growth, driven by low inflation, has further limited corporate profitability, as tax collections, government spending and business earnings typically move in tandem with nominal growth. Smaller companies, with relatively weak pricing power, have also faced margin compression, leaving them more exposed during periods of economic softness.

What small-cap fund returns show

Despite these headwinds, fund-level performance tells a more nuanced story. Since December 2024, the BSE Smallcap index has declined sharply by about 21%. Yet, nearly 90% of small-cap mutual funds have managed to outperform the benchmark over this period, reinforcing the case for active management in the segment. While the broader index struggled, several actively managed schemes were able to cushion investor losses through selective stock picking, disciplined risk management and relatively defensive portfolio positioning.

An analysis of small-cap mutual fund returns across multiple timeframes indicates that, despite the sharp correction in the segment, actively managed schemes have provided meaningful downside protection relative to broader market trends. This reinforces the case for active investing in small-cap equities.

Small-cap fund returns

In the short term, the category has been under pronounced pressure. One-month, three-month and six-month returns for most small-cap funds remain in negative territory, reflecting weak market breadth, elevated risk aversion and sustained selling across mid- and small-cap stocks. The category’s average return stood at around –7.7% over one month, deteriorated to nearly –10% over three months, and slipped further to close to –12% over six months.

Importantly, performance dispersion across funds highlights the role of fund-level decisions in containing losses. While some schemes posted double-digit declines over six months, others limited drawdowns to mid-single digits, indicating relatively defensive portfolio positioning, selective exposure and disciplined stock selection.

One-year performance data provides clearer evidence of downside resilience. The category average return over this period was approximately –4.5%, notably better than the broader correction witnessed in small-cap equities during the same timeframe. Several funds managed to keep losses well below the category average, while a few delivered positive returns despite the challenging market environment.

Quantum Small Cap Fund emerged as a notable outlier with a positive one-year return, underscoring the benefits of a conservative, valuation-driven investment approach. TRUSTMF Small Cap Fund and Sundaram Small Cap Fund also stood out by containing losses to mid-single-digit levels, helping preserve a significant portion of investor capital during the downturn.

Longer-term data further strengthens the argument for remaining invested in quality small-cap funds through market cycles. Over a three-year period, the category delivered an average compounded annual growth rate (CAGR) of around 18%. Five-year returns for available schemes remained firmly above 20% on average. The sharp contrast between short-term volatility and long-term wealth creation highlights the cyclical nature of small-cap investing and the importance of maintaining a sufficiently long time horizon.

Overall, the data suggests that while small-cap funds are not immune to market corrections, active management has helped cushion investor losses during the recent downturn. Funds that emphasised balance sheet strength, reasonable valuations and risk control have clearly fared better, supporting the view that active strategies can add value in an inherently volatile segment.

What investors should note

The recent correction does not necessarily warrant panic selling. While volatility remains elevated, staggered investments rather than lump-sum allocations can help manage timing risk. The reopening of some schemes for fresh inflows also indicates improving opportunity visibility from a fund management perspective.

This divergence between index-level performance and fund outcomes highlights the role of active investing in navigating small-cap volatility. Even amid a broad-based correction, fund managers focusing on balance sheet strength, valuation discipline and earnings visibility have helped limit drawdowns, offering investors relatively better downside protection during a challenging phase for the asset class.

That said, small-cap investing carries distinct risks, including liquidity constraints, sharp price swings and uneven corporate governance standards. A long-term investment horizon of at least seven to ten years, disciplined investing through SIPs or STPs, and measured portfolio allocation aligned to individual risk appetite remain critical to navigating this category effectively.