Small-cap funds see rising inflows: Are Indian investors chasing returns at cost of risk? Experts explain

Over the last six years, Indian mutual fund investors have increased their exposure to small-cap funds. Each year, inflows into small-cap funds rose, while inflows into large-cap funds did not grow at the same pace.

Small-cap funds attracted ₹1,386 crore in 2020 and surged to ₹52,321 crore last year. In comparison, large-cap funds saw an outflow of ₹2,356 crore in 2020. Although they attracted ₹25,483 crore in 2025, inflows remained significantly lower than those of small-cap funds, according to annual data published in the NSE Market Pulse, January 2026.

This trend has continued in 2026. AMFI monthly data showed that small-cap funds led growth in the equity segment in July, with inflows rising to ₹7,768 crore from ₹5,602 crore in June, an almost 39% jump. Meanwhile, large-cap funds saw an outflow of ₹1,322 crore.

Small-cap investing involves higher risk than many large-cap-oriented schemes, as small-cap stocks can experience sharp price movements in both rising and falling markets. Additionally, shares of smaller companies may be traded less frequently than large-cap stocks, which can impact liquidity.

At first glance, this seems like a shift in how Indians invest. Earlier, investors, including our parents, often preferred fixed deposits, government schemes or real estate, as these options offered relatively predictable returns. But with many young individuals turning to market-linked products, new-age investors appear more comfortable with risk. Here's what experts have to say.

Are investors becoming more risk-taking?

Explaining this shift, Hyderabad-based Wert Finserve's Prithvi Potta, said the previous generation invested in plots, LIC and post-office schemes, FDs offering 11–15% returns and physical gold. These investments also carried risks such as title disputes, encroachment, theft, reinvestment risk, but unlike market-linked assets, they did not show a daily price, he added.

“Investors were never truly risk-averse; they were risk-blind,” Potta said. He explained that the real differentiator was never the asset class but the investor's ability to safeguard, diversify and stay patient.

Speaking of factors driving the appetite for small-cap funds, Harendra Zatakia, a Sebi-registered investment advisor and the Founder of Wealth Aligned Financial Advisory, said the most obvious factor was the segment's recent return performance.

“Smallcaps and midcaps have done well relative to large caps over several periods, and investors naturally notice where returns have been better,” he said.

A lot of India's newer growth themes, defence manufacturing, capital expenditure, electronics, manufacturing, digital businesses, fintech, logistics and new-age consumption are not yet fully represented in the traditional large-cap universe, Zatakia adds. “Some companies have already graduated into the large-cap space, but a significant part of this opportunity set is still in the mid- and small-cap universe,” he said.

When does small-cap exposure become excessive?

According to Potta, exposure to small-cap funds becomes excessive when these funds stop being part of the portfolio and become the entire portfolio, putting investments at risk of losses due to less diversification.

This typically happens when investors put a large lump sum into small-cap funds after a sharp rally, stop SIPs in large-cap, flexi-cap or multi-cap funds because small-cap funds are outperforming.

Potta advised a practical approach: keep the larger share in steady large-cap or flexicap funds and treat small and midcaps as an add-on, roughly 25–35% of the equity portion.

“Going higher would be safe only for someone with a long working life, stable income and the temperament to sit through a fall,” he said.

Zatakia added that a practical approach would be to avoid relying heavily on small-cap performance if you needed money for a goal within the next three to five years. Someone investing for a goal 15–20 years can take a different level of equity risk.

“But I also look at behavioural risk tolerance. I would ask an investor a very simple question: If your small- and mid-cap allocation falls 40%, what will you do? If the honest answer is that they would probably sell, then the allocation is probably already too high,” he said.

Small-cap funds overvalued: Should you still invest?

DSP Mutual Fund's recent NETRA report showed the Nifty 50 trading at a trailing P/E of 20.5 times, close to its long-term average. Small- and mid-cap stocks, meanwhile, were trading at a median P/E of 38 times, compared with their long-term average of around 20 times. The data indicated that large-cap funds have more comfortable valuations.

However, Zatakia said, while valuation should influence allocations, it should not determine them by itself. The valuation data show that investors are clearly paying a much higher price for the growth they expect from smaller companies, he added.

“That doesn't automatically mean small-caps should be avoided. A company can justify a higher valuation if its earnings, return on capital and cash flows can compound faster for a longer period. Equally, a low P/E does not automatically make a company attractive,” he says.

He advised investors to use valuation more as a tool for managing expectations and position sizing, rather than as a simple buy-or-sell signal.