Small cap funds have rallied recently despite the ongoing uncertainty, delivering category average returns of 7.76% in the three months to 31 May, compared to 3% for mid cap funds and negative 4% for large cap funds.
With this, investor interest in small cap funds appears to be gaining fresh momentum. According to data from the Association of Mutual Funds in India (Amfi), small cap funds drew net investor inflows of ₹6,885 crore in April, the highest in a year.
Here’s a look at how small cap funds have performed, what's driving this rally, and what investors should do.
Small cap fund performance
Small cap funds delivered a category average return of 3.13% over six months and 6.42% over one year (as of 31 May 2026). However, their long-term performance remains robust, with a three-year annualized category average of 19.4%.
Small cap funds also have a strong long-term record when measured against their benchmark. About 92.3% of active small cap funds have beaten the Nifty Smallcap 250 TRI over the past 10 years, 81.8% over the past five years, and 80% over the past 12 months.
However, the data also underscores that small cap funds are not meant for investors with a short investing horizon. An analysis of rolling returns of the Nifty Small Cap 100 Index since its inception on 1 April 2004 shows the probability of negative returns tends to diminish over the long term. Over a three-year systematic investment plan (SIP) horizon, the worst outcome is negative 44%, while over five years it is negative 16.3%. Stretch the horizon to 10 years and the worst outcome narrows further to negative 2.4%. At 15 years, the smallest SIP return is 6.1% annualized.
"Small cap funds are not meant for risk-averse or cautious investors, as they tend to be significantly more volatile than large cap funds or the broader market," said Nilesh Naik, head of PhonePe Mutual Funds. Small cap funds can be more vulnerable to broader economic stress as these companies lack the balance-sheet strength of larger companies.
The valuation case
Following a sharp correction between September 2024 and early 2026, a significant portion of small cap stocks are trading at a discount to their valuations, according to a note by Bajaj Finserv Mutual Fund. As of April, 50% of small-cap stocks were trading at a discount to their 10-year average one-year forward valuations — up from just 19% in September 2024.
"Small caps have corrected over the past two years, even before the West Asia crisis, and have now become attractive," said Neelesh Surana, chief investment officer at Mirae Asset Mutual Fund. "Those with a long-term view can accumulate, as a likely mean reversion in earnings, once the conflict is settled, could lead to decent upside given the attractive valuations."
Why are small caps rallying now?
The recent recovery in small caps is due to a combination of factors, experts said.
Pratik Dharmshi, fund manager, equity, at Union Asset Management, said, “Earnings growth has improved over the past two quarters and most of the outperformance has come from capex and manufacturing-linked sectors—industrials, along with financials and select healthcare names.”
Sorbh Gupta, head of equity at Bajaj Finserv Mutual Fund, said, "India remains in the midst of a cyclical economic recovery. Fiscal measures such as the income tax cuts and GST reductions announced last year, along with the RBI's 125 basis points of monetary easing in 2025, have created strong domestic macro tailwinds.”
Alok Singh, chief investment officer at BOI Mutual Fund, said the rally also reflects a broadening of economic activity. "High-frequency data has been suggesting that the economic activity has turned more broadbased—that is being reflected in earnings, and that is what is leading to this move in small caps," he added.
According to Manish Gunwani, chief investment officer, equity, at Bandhan Asset Management Company, the large cap index is more heavily weighted toward the domestic cycle—financials, fast-moving consumer goods and automobiles. "But small caps offer a much broader opportunity set. Investors can play themes such as electrification, data centre capex, transformers, HVDC (high voltage direct current) equipment and specialized exporters—opportunities that are not adequately represented in large cap indices," he said.
What should investors do?
"A good small cap fund will generally produce alpha over large caps, provided investors are patient," said Gunwani. "You cannot approach small caps with a three- to six-month mindset. This has to be patient capital," he added.
"You need at least a five-to-seven-year horizon when looking at small cap funds," said Ankur Punj, managing director and business head at Equirus Wealth. He said investors should choose a fund with a consistent track record across market cycles rather than one that has performed well recently.
On allocation, Punj said, "Investors who want to allocate to small caps to capture sectors that don't get coverage in mid- and large-cap funds can consider up to 10% allocation to small-cap funds. More aggressive investors can consider up to 15-20%." Fund managers and financial planners recommended using SIPs to invest in small cap funds to deal with its volatility.
Exposure via flexi, multi cap funds
Investors can also get exposure to small caps without buying dedicated small cap funds. Many flexi cap and multi cap funds have varying degrees of exposure to small cap stocks, offering a more diversified and cushioned way to capture their growth potential. For investors wary of small cap volatility, these options offer a practical middle ground.
Flexi cap funds are typically large-cap oriented, with some exposure to mid- and small-caps at the fund manager's discretion, while multi cap funds are required to maintain 25% allocation each to large cap, mid cap and small caps, with remaining 25% left to the fund manager's discretion.