Small-cap mutual funds have long been viewed as a preferred choice for investors seeking superior returns, but a new analysis suggests that the additional gains generated by the category over the long term may not adequately compensate for the significantly higher risks involved.

According to a report by Share.Market, an analysis of 20 years of historical data comparing the performance of small-cap and large-cap market segments found that while small caps have outperformed over the long run, the margin of outperformance has been relatively modest.

The study used the Nifty Small Cap 250 TRI and the Nifty 100 TRI as proxies for the small-cap and large-cap segments, respectively.

Over the past two decades, the Nifty Small Cap 250 TRI delivered an annualised return of 12.54%, compared with 11.72% for the Nifty 100 TRI, translating into an outperformance of just 0.82 percentage points. However, the higher returns came with considerably greater risk. Annualised volatility for the small-cap index stood at 28.81%, significantly higher than the 21.06% recorded by the large-cap benchmark. The small-cap index also experienced substantially deeper drawdowns.

The report highlighted that small-cap performance relative to large caps varies sharply across shorter investment horizons. For instance, over rolling three-year periods, the annualised outperformance of the Nifty Small Cap 250 TRI ranged from an underperformance of 17.16% to an outperformance of 20.52%.

Cyclical nature of small-cap investing

The findings also underscore the cyclical nature of small-cap investing. Small caps have historically outperformed during bullish market phases, such as 2014-2017 and 2020-2024, while significantly lagging large caps during correction phases, including the 2010-2013 period.

Given this trend, the report cautioned that small-cap funds may not be suitable for conservative investors due to their elevated volatility. While aggressive investors with a higher risk appetite may consider exposure to the segment, the report argued that a simple buy-and-hold strategy may not be the most effective approach, as the incremental long-term returns often do not adequately compensate for the higher risk.

Instead, the report suggested a tactical allocation strategy, whereby investors increase exposure to small-cap funds when they significantly underperform large caps and reduce allocations after periods of strong outperformance.

The report noted that the performance gap between small-cap and large-cap stocks has narrowed over the past two years due to a time correction in the market. As a result, valuations in the small-cap segment have become more reasonable, potentially creating an attractive investment opportunity over the next 12 to 18 months.

It also stated the importance of fund selection in the small-cap category, given its extreme cyclicality and the critical role of stock picking. According to the report, funds that have demonstrated consistent performance relative to peers and maintain a bias towards quality and value-oriented investing may be better positioned to manage risks while delivering long-term returns.