Small-cap mutual funds are losing money, but investors are still pouring thousands of crores into them. Even as fund values decline and market volatility increases, the appetite for small-cap investing appears largely undiminished.
Is this a sign of growing investment discipline, or are retail investors underestimating the risks?
The answer matters to millions of investors who use systematic investment plans (SIPs) to build long-term wealth. Investing regularly during a market correction can help accumulate more units at lower prices. But it does not guarantee attractive returns.
Small-cap stocks can remain under pressure for years. Investors who enter these funds without understanding the risks could face prolonged losses, particularly if they need their money before markets recover.
The latest correction has once again brought these concerns into focus.
Small-cap mutual funds have witnessed a sharp decline in recent weeks. According to Value Research category-level data, these funds lost 8.60% over one month and 4.42% over three months. Their one-week decline stood at 4.62%.
Mid-cap funds also recorded significant losses, falling 7.20% over one month and 7.36% over three months. Their one-week decline was 3.18%.
Small-cap funds suffered a sharper one-month correction, while mid-cap funds recorded greater losses over three months.
For investors accustomed to strong returns during bullish market conditions, these declines serve as a reminder that smaller companies generally carry greater volatility and investment risk than established large-cap businesses.
Despite the losses, investors have continued allocating substantial amounts to small-cap mutual funds.
One of the main attractions of SIP investing is rupee-cost averaging. When a mutual fund's net asset value (NAV) declines, the same monthly investment purchases more units.
Consider an investor contributing ₹5,000 every month. At an NAV of ₹50, the investment purchases 100 units. If the NAV declines to ₹40, the same amount purchases 125 units.
This allows investors to accumulate more units without increasing their monthly contributions. If markets eventually recover, the additional units purchased at lower prices can help improve overall returns.
However, the strategy has an important limitation.
Accumulating more units does not automatically translate into higher returns. If the underlying investments continue to lose value, the investor's portfolio can remain in negative territory despite years of regular contributions.
Rupee-cost averaging reduces dependence on choosing a single entry point. It does not eliminate market risk.
Yes. Regular investments do not guarantee profits, particularly in volatile segments such as small-cap stocks.
The 2018-2020 downturn demonstrated how smaller companies can experience prolonged weakness. Investors who entered near market peaks faced substantial declines and a difficult recovery.
A similar situation can affect SIP investors if company earnings deteriorate, valuations remain expensive or overall market sentiment weakens.
Even investors who continue contributing regularly may find that their portfolio value remains below the cumulative investment amount for an extended period.
Returns also depend on when each instalment was invested and how markets subsequently perform.
A SIP investor who purchases units throughout a correction may experience a different outcome from someone who invested a lump sum near the market peak.
Nevertheless, neither approach guarantees protection against losses.
Investors often assume that a sharp fall will be followed by an equally strong recovery. However, small-cap stocks may remain depressed for several years if earnings growth slows or valuations contract.
Lower NAVs allow investors to accumulate additional units. But if those units continue losing value, the overall investment may still generate negative returns.
Investors holding a disproportionately large share of their equity investments in small-cap funds face heightened concentration risk.
A prolonged downturn could significantly reduce their overall portfolio value.
Smaller companies generally have lower trading volumes than large-cap stocks. During heavy market selling, mutual fund managers may find it difficult to liquidate significant holdings without affecting prices.
Investors may enthusiastically increase SIP contributions during an initial correction but abandon their investments if losses deepen.
Stopping investments out of fear can undermine long-term plans, while continuing blindly can expose investors to unsuitable risks.
Small-cap funds are generally unsuitable for money required in the near future.
Investors saving for education, property purchases or other approaching financial commitments could be forced to redeem investments during a market downturn.
The Securities and Exchange Board of India (SEBI) requires mutual fund houses to publish monthly stress-test disclosures for small-cap and mid-cap schemes.
These disclosures are intended to help investors understand the liquidity risks associated with fund portfolios. Among other things, stress tests indicate how long a scheme could take to liquidate portions of its portfolio under specified market conditions.
This information is particularly important for small-cap funds because many underlying stocks have relatively limited market liquidity.
However, investors should not mistake stress-test results for predictions of future returns.
A fund that demonstrates relatively better liquidity can still suffer substantial NAV declines during a market correction.
Stress-test disclosures should therefore be examined alongside portfolio concentration, investment strategy, historical volatility and the fund's overall risk profile.
A correction in small-cap funds does not automatically mean every investor should discontinue SIPs or shift investments elsewhere. The appropriate response depends on individual financial circumstances.
Investors with long investment horizons, adequate emergency savings and a sensible allocation to small-cap funds may be able to continue investing through the downturn.
However, those who have accumulated excessive exposure to smaller companies should consider rebalancing their portfolios. Large-cap funds invest predominantly in established companies, while flexi-cap funds have the flexibility to allocate investments across large-, mid- and small-cap stocks. Redirecting future SIP contributions towards these categories may help investors reduce concentration risk.
Nevertheless, large-cap and flexi-cap funds are not immune to market declines.
Investors approaching important financial goals may need to reduce overall equity exposure rather than merely switch between equity fund categories.
The correction provides an opportunity to reassess investment strategies rather than react emotionally to falling fund values.
Before increasing, reducing or discontinuing small-cap SIPs, investors should consider the following:
Review the proportion of small-cap and mid-cap investments in the overall portfolio.
Check whether the investment horizon is long enough to withstand an extended market downturn.
Maintain adequate emergency savings without depending on volatile equity investments.
Examine the fund's portfolio composition, investment strategy and stress-test disclosures.
Avoid increasing exposure simply because NAVs have declined.
Rebalance investments if small-cap exposure exceeds the planned allocation.
Keep money required for near-term financial goals away from highly volatile investments.
The decision to continue a SIP should be based on financial goals, risk tolerance and portfolio allocation rather than recent market movements alone.
The continuing inflows into small-cap mutual funds suggest that investors remain willing to commit money despite falling markets. That can be encouraging if it reflects an understanding of long-term investing and the risks involved.
But investment discipline should not be confused with continuing every SIP regardless of changing circumstances.
Small-cap funds can offer growth opportunities over extended periods, but they also carry substantial volatility, liquidity concerns and the possibility of prolonged underperformance.
For investors, the important question is not whether small-cap funds will recover next month or next year.
It is whether their portfolio can withstand a prolonged downturn without compromising essential financial goals.
Regular investing is a useful wealth-building habit. Combining that discipline with appropriate asset allocation and risk management is what makes the strategy sustainable.