Small-cap mutual funds have emerged as the fastest-growing equity category in India, with investor folios expanding nearly five-fold over the past five years. This surge reflects growing retail confidence — but also raises a critical concern. Are investors entering small-cap funds with a realistic understanding of risk, or are they simply extrapolating recent high returns into the future? Given the structural fragility of small-cap companies, this distinction matters deeply for long-term outcomes.
What defines small-cap investing?
Small-cap companies typically represent early-stage or relatively smaller businesses with limited market capitalisation. These firms often operate with thinner margins, weaker balance sheets, lower liquidity, and higher dependence on economic cycles. Governance standards may also be uneven. While such companies can scale rapidly in favourable conditions, they are far more vulnerable during economic slowdowns or liquidity shocks.
For investors, this translates into a segment that can generate outsized returns — but only at the cost of significantly higher volatility and behavioural stress.
Why drawdowns are the biggest test
The most defining risk in small-cap funds is the depth of drawdowns during market corrections. Historically, small-cap indices have fallen far more sharply than mid- and large-cap indices in crises. During the global financial crisis, small-cap indices lost roughly three-fourths of their value at the trough, while large-cap indices declined far less.
Such deep drawdowns have two implications. First, recovery periods become longer, often stretching over several years. Second, investor behaviour becomes the biggest risk factor. Many investors exit after steep falls, locking in losses and missing eventual recoveries. Small-cap investing, therefore, demands both financial capacity and emotional resilience to withstand severe interim losses.
Extended underperformance cycles
Unlike large-caps, which tend to recover steadily after downturns, small-caps often move in long, uneven cycles. Sharp rallies are frequently followed by prolonged phases of stagnation or underperformance. Historical data shows periods of five to seven years where small-cap indices delivered little to no returns on a point-to-point basis.
Higher volatility worsens this experience. With wider price swings, even long-term investors face prolonged periods of disappointment before meaningful compounding resumes. This makes small-caps unsuitable for investors with shorter horizons or return expectations anchored to recent market performance.
SIPs help — but they don’t eliminate risk
Systematic Investment Plans (SIPs) are often presented as a solution to volatility, and rightly so — to an extent. During prolonged downturns, SIPs benefit from accumulating more units at lower prices, which can significantly improve long-term returns compared to lump-sum investing.
However, SIPs are not a magic shield. Data shows that even long-duration SIPs in small-cap indices have occasionally delivered muted or even negative returns over extended rolling periods. During extreme market stress, small-cap SIPs can underperform large-cap SIPs for several years, testing investor patience despite disciplined investing.
Why patience alone is not enough
A common misconception is that time automatically neutralises risk. In small-caps, time helps only if investors also manage allocation size, rebalance periodically, and maintain realistic expectations. Prolonged volatility can distort portfolios, inflate exposure during rallies, and amplify regret during downturns. Without active risk management, long holding periods may still result in suboptimal outcomes.
Building a disciplined small-cap strategy
A prudent approach to small-cap investing rests on a few non-negotiable principles:
- Risk tolerance first: Investors must be comfortable with 30–60% drawdowns and multi-year underperformance.
- Long horizon: A minimum investment horizon of 7–10 years is essential.
- Limited allocation: Small-caps should remain a satellite allocation — typically 5–15% of the equity portfolio.
- Prefer SIPs: Regular investing reduces timing risk and enforces discipline.
- Periodic rebalancing: Annual rebalancing helps control risk and lock in gains after sharp rallies.
- Thoughtful fund selection: Investors should choose between active, passive, or smart-beta funds based on conviction, cost sensitivity, and risk appetite.
What to note for Prelims?
- Small-cap stocks exhibit higher volatility and deeper drawdowns than large-caps.
- SIPs reduce timing risk but do not eliminate market risk.
- Higher standard deviation implies greater price variability and behavioural risk.
What to note for Mains?
- Discuss the risk-return trade-off in small-cap investments.
- Examine behavioural finance challenges faced by retail investors during drawdowns.
- Analyse why asset allocation and rebalancing are critical in volatile equity segments.
