Small caps continue to attract strong inflows. But can investors handle the volatility? What history reveals

Indian investors are continuing to put money into small-cap funds even as the equity market remains volatile. In August, small-cap mutual funds attracted ₹7,973 crore, while overall equity mutual fund inflows rose nearly 19% from the previous month to ₹29,328 crore. SIP contributions also touched a record ₹32,297 crore.

That makes the behaviour of small caps particularly relevant for investors. A FundsIndia analysis of historical market data shows that investors in this segment have had to endure substantially deeper declines than those seen in large-cap indices.

How often do small caps actually fall?

The easiest way to understand the difference is to look at drawdowns. A drawdown measures the fall in an index from an earlier peak. It tells investors how deep the decline became during a period, rather than simply looking at where the index started and ended the year.

FundsIndia's analysis shows that small-cap drawdowns have historically been much more frequent and severe than those in the Sensex.

The difference is striking. A decline of more than 10% from a previous peak occurred on 63% of the observed days for the Nifty Smallcap 100, compared with 33% for the Sensex.

For a decline of more than 20%, the difference widens further. It was seen on 45% of the observed days for the Nifty Smallcap 100, compared with 11% for the Sensex.

And when the decline crossed 30%, the Nifty Smallcap 100 recorded it on 36% of the observed days, compared with just 4% for the Sensex. In other words, a 30% drawdown is not an unusual historical event for small caps in the way it would be for large-cap stocks.

FundsIndia also notes that small caps are more volatile than large and mid caps and have witnessed temporary declines of 15% to 30% almost every year. Only one of the last 22 calendar years had an intra-year decline of less than 10% for the Nifty Smallcap 100.

But a sharp fall does not always mean a bad year

This is where the historical data becomes more useful for investors.

If an investor looks only at the maximum fall during a year, it can create the impression that the market had a disastrous year. But the maximum drawdown and the final calendar-year return measure two different things.

Consider 2020. The Nifty Smallcap 100 fell as much as 38% from its previous peak during the year. Yet the index ended 2020 with a 16% positive return.

The same pattern can be seen in other years.

The 2022 example is also important. Small caps fell 16% from their previous peak during the year, but the index still finished the year with a 4% gain.

FundsIndia's broader analysis found that despite intra-year declines of more than 15% occurring almost every year, three out of four years ended with positive returns. It also found that markets ended the year positively 68% of the time, indicating that many of the declines were temporary and subsequently recovered.

This does not mean every fall will recover. It shows why the size of an intra-year correction should not be confused with the final investment outcome.

What does this mean if you are investing in small-cap funds?

The data points to a very different risk experience for small-cap investors compared with large-cap investors.

An investor in a small-cap fund needs to be prepared for periods when the portfolio falls sharply from its previous high. A 10%, 20% or even 30% decline should not automatically be treated as an extraordinary event for the category. Historically, such drawdowns have occurred far more frequently in small caps than in large caps.

At the same time, investors should not interpret the historical recovery data as a guarantee that a future correction will reverse. The FundsIndia analysis is based on historical Nifty Smallcap 100 data and shows what has happened in the past, not what investors should expect in every future market cycle.