Will the heated small-cap universe burst into flames?

Summary: Small-cap funds are pulling record inflows in 2025, but fund managers are flashing valuation and liquidity warnings. This story explores why rising popularity introduces new risks, how active funds mitigate volatility more effectively than passive indices, and why investor discipline—not performance chasing—will ultimately determine outcomes in this high-reward, high-risk corner of the market.

Summary: Small-cap funds are pulling record inflows in 2025, but fund managers are flashing valuation and liquidity warnings. This story explores why rising popularity introduces new risks, how active funds mitigate volatility more effectively than passive indices, and why investor discipline—not performance chasing—will ultimately determine outcomes in this high-reward, high-risk corner of the market. Small-cap funds are once again in the spotlight. In 2025 alone, they have attracted more than 15 per cent of all equity mutual fund net inflows, making them the second-largest beneficiary after flexi-cap funds. The enthusiasm peaked in July, when the segment pulled in a record Rs 6,484 crore, a 61 per cent jump over the previous month and the highest-ever monthly inflow for the category. And yet, fund managers caution about stretched valuations in this space. In an interview with Moneycontrol, Sailesh Raj Bhan, President & Chief Investment Officer of Nippon India Mutual Fund, which runs India’s largest small-cap fund, noted that nearly two-thirds of the mid- and small-cap universe still looked overvalued. Given the precarious nature of the SMID (small and mid cap) space, can the surge in inflows be absorbed without causing any repercussions? Why inflows themselves create risk In large caps, a surge in investor money rarely moves prices much. However, small caps are different. Their market-cap universe is narrow, trading volumes are thinner and free float is limited. Even modest allocations can push prices disproportionately. Take Nippon India Small Cap, the biggest small-cap fund in I