Even though there were clear signs that small-cap stocks had lost steam, investors still put in record amounts of money into small-cap mutual funds. This went against normal market thinking and created a surprising gap between investor confidence and actual performance.

According to the Association of Mutual Funds in India, small-cap mutual funds have witnessed net inflows of ₹20,749 crore in only five months till May. Even as the market regulator, Securities and Exchange Board of India, and fund houses urged caution and restraint a few months ago, retail investors have largely shrugged off these warnings—some even emboldened by the memory of stellar past returns.

“Over the past two decades, the small-cap segment has demonstrated periods of powerful earnings growth and substantial market returns," says Varun Goel, senior fund manager, Mirae Asset Investment Managers (India). "Small companies tend to be nimbler and more responsive to changing market dynamics. Their ability to scale rapidly often translates into sharp earnings growth, which the market rewards handsomely, though not without considerable risk.”

Anand K. Rathi, co-founder of MIRA Money, says, “When markets corrected earlier, small-caps were the first to fall, dropping nearly 30%, compared to just 17% in large caps. While small-caps have rebounded about 30% from their recent lows, they remain well below their all-time highs seen around September 2021 to 2024.”

Small-cap stress

Small- and mid-cap stocks tend to be more volatile than their large-cap counterparts, and geopolitical tensions only magnify this exposure. Many such companies have narrow business models, thinner balance sheets, and fewer buffers to weather global turbulence.

However, Goel remains cautiously optimistic. "Recent geopolitical tensions in South Asia, the Middle East, and Europe have indeed raised volatility, but their direct impact on Indian small- and mid-cap firms is expected to remain limited," he says.

"Yes, sectors reliant on global growth may face near-term pressure, but domestic consumption and infrastructure-linked themes look resilient, especially with India’s current monetary easing cycle gaining traction.”

He further adds that earnings growth for Indian small-caps is likely to rebound from its current cyclical low in FY25, powered by tax relief, heavy government infrastructure spending, and a supportive Reserve Bank of India. “The building blocks for a growth rebound are in place,” Goel says.

Why small-caps continue to attract money

In the past 20 years, the small-cap universe has experienced multiple sharp corrections—some severe, some short-lived. Yet time and again, these periods have presented opportunities disguised as pullbacks. The current phase appears no different.

“Historically, small-caps have tended to outperform during post-correction recoveries, and with increased focus on India’s domestic economy and a pickup in consumption, many of these companies are positioned for stronger earnings. Valuations are no longer cheap, but they are not irrational either. For investors with the right risk appetite and time horizon, selective exposure to small-caps can still add value to a diversified portfolio,” adds Rathi.

A key driver of the recent inflows is the steadfast commitment to systematic investment plans, Goel said. “Retail investors today appear more disciplined and long-term in their approach. Even amid corrections, many see this as a time to build exposure at better valuations, rather than retreat. That shift in mindset is perhaps the most promising trend of all.”

In an era dominated by short attention spans and algorithmic trades, the retail investor’s resilience and patience in the small-cap space stand out. Whether this optimism is prescient or premature remains to be seen, but for now, small-caps continue to punch above their weight when it comes to investor faith.