Smallcap funds beat all equity mutual fund categories over 3 months. Should investors change SIP strategy?

Over the past three months, smallcap funds have been the best-performing equity mutual fund segment, delivering an average return of 16.94%, as per ETMutualFunds data. This surge follows an earlier correction this year and has been fuelled by better earnings, renewed investor appetite and ample liquidity in the small-cap universe.

The sharp upswing has, however, left investors wondering whether they should raise their smallcap exposure now, wait for more attractive entry points, or start booking profits.

Pallav Agarwal, Certified Financial Planner at Bhava Services LLP, told ETMutualFunds that small-cap company earnings grew about 25% year-on-year in the latest quarter. According to him, this earnings revival, combined with relatively cheap valuations after an 18‑month correction, set the stage for the strong bounce-back.

Agarwal also advised that investors should avoid increasing allocations after a roughly 17% run-up and instead book profits in line with their pre-decided asset allocation.

Another expert, Nilesh D Naik, Head of PhonePe Mutual Funds, pointed out that from the peak to the recent bottom in March, smallcap funds corrected more sharply than largecap funds.

Naik highlighted that as of 31 March 2026, the Nifty Smallcap 250 Index was down around 23% from its peak, versus a roughly 15% decline in the Nifty 100 Index. During such drawdowns, even fundamentally strong, quality stocks fall, but they typically recover once conditions stabilise.

As markets rebounded over the last three months, many actively managed smallcap funds with a focus on stronger fundamentals were able to post robust returns, he added.

Beginning of a sustained rally or just a rebound?
In this three-month period, smallcap funds have outperformed every other equity mutual fund category, including international funds, which have otherwise been leaders across several time frames. International funds returned an average of 14.33% in the same window.

Other categories that managed double-digit average returns were infrastructure funds (12.19%), pharma and healthcare funds (11.17%), and midcap funds (10.86%). The remaining 16 equity categories delivered average returns between 3.68% and 9.98% over these three months.

The recent performance has revived interest in smallcap funds, but experts are hesitant to call it the start of a long-term bull phase.

Naik noted that over the last three years, smallcap funds have beaten largecap funds by about 5–6% per year on average, though the degree of outperformance has narrowed compared with earlier periods. He believes the current move looks more like a rebound after the correction, especially in light of the earnings trends seen in the final quarter of FY26.

Agarwal pointed out that the BSE Smallcap Index has already risen nearly 19% from its March 2026 low, with liquidity playing a bigger role than fundamentals in driving the rally. In his view, this appears to be a mean-reversion move for now, and the uptrend can continue only if earnings growth stays strong in the coming quarters.

Better placed than large and flexi-caps?
Tata Mutual Fund’s Equity View – June 2026 states that the risk–reward currently favours largecaps, with selective positions in mid- and smallcaps in preferred sectors. It notes that the Nifty Smallcap 100’s one-year forward P/E is at 22.6, well above its long-term average of 16.9 times.

The note also emphasises that smallcaps are trading at richer valuations than largecaps and global peers. On current metrics, largecaps look more attractive from a risk–reward perspective.

Given the valuation expansion after the recent rally, Agarwal said that SIPs are clearly preferable to lump-sum investments in smallcap funds at this stage. He suggested that exposure to pure smallcap funds should ideally be built only through long-term SIPs spanning 7–8 years.

He further mentioned that flexicap funds presently offer better risk-adjusted potential, as they can hold quality smallcaps within a diversified portfolio, provided investors have at least a five-year horizon.

Naik also recommends the SIP approach. In his view, considering current valuations and earnings patterns, SIPs are a more suitable way to invest in smallcap funds in the present environment.

Performance of small caps
Over the last three months, there were 35 smallcap schemes in the market. Among them, Bank of India Small Cap Fund delivered the highest return at about 27.24%. Nippon India Small Cap Fund, the largest scheme in this segment, returned 15.48%, while HDFC Small Cap Fund recorded the lowest return at 8.97% for the period.

Across longer time frames of six months, one year, three years and five years, smallcap funds have regularly featured among the top five or six categories across all equity mutual fund segments.

Naik observed that smallcap fund performance is more cyclical than that of large- and midcap funds. Because of their higher volatility and the need for more active oversight, he believes they are better used as tactical allocations within portfolios.

He also cautioned that, given current valuations and earnings trends in the smallcap space, investors should tone down their return expectations from this category in the short to medium term.

Agarwal added that smallcap index valuations now appear somewhat stretched. For the segment to replicate its past stellar returns, strong earnings growth will have to continue. With crude oil prices staying elevated this quarter and supply chain issues arising from shipping disruptions, corporate margins could face pressure. He concluded that the phase of easy gains in smallcaps may be over and described the outlook as “optimistically cautious.”

(Disclaimer: Recommendations, suggestions, views and opinions expressed by the experts are their own and do not represent the views of The Economic Times.)

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