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Summary: Spectacular gains and gut-wrenching crashes, small-cap funds offer both in spades. This piece explores why they tempt investors, how they can burn portfolios and what role (if any) they should play in yours.
“Guess how much my small-cap fund returned in three years?” my cousin grinned at the dinner table, waving his phone for everyone to see. “It’s nearly double!”
Everyone around was impressed. I nodded too as I spooned dal onto my bowl. But inside, I reminded myself of the flipside I’d seen before.
The same funds that double fast can halve just as quickly. It’s hard not to feel a pang of envy, but harder still to ignore the risks I know too well.
Why the lure of small-cap funds is hard to resist
The thrill of small caps is like treasure hunting. These funds invest in companies ranked beyond the top 250 by free float market value—smaller, less established businesses still making their way up. For every dud, there’s the possibility of discovering a diamond.
I often hear investors talk about Titan or Eicher Motors. Both were once obscure small caps before transforming into household names. The fantasy is simple: what if you spot the next Titan early?
I still remember a colleague telling me, “It feels like being part of a secret, buying into tomorrow’s giant before the world catches on.”
Between 2020 and 2023, that dream looked very real. The Nifty Smallcap 250 posted stellar double-digit annualised returns of over 30 per cent, far ahead of the Nifty 50’s 17 per cent per annum. Friends, people on Telegram groups—even the usually cautious ones—were suddenly asking, “Should we add small caps now? Everyone seems to be making money?”
I understood the temptation. Who wouldn’t want to join the party?
The risks I can’t ignore
But here’s the catch. Small caps aren’t simply large caps in their toddler years. Some may grow into giants, yes, but many may remain small or even disappear along the way. Small caps are smaller for a reason. Many small caps have limited market share, patchy balance sheets, dependence on promoters, or no real moat.
The first time I invested in a small-cap fund, I learned this the hard way. Within six months, my portfolio was down nearly 20 per cent. That’s when I realised what people meant by volatility. Small caps soar in good times but crash harder in downturns. In 2008, they lost more than 70 per cent from their peak. Even in 2018, while large caps stayed afloat, small caps bled nearly 60 per cent.
Then there’s liquidity risk. I remember an interview where a fund manager explained how he struggled to exit a stock. He laughed wryly: “Try selling 2 per cent of a company’s equity when only a few thousand shares trade daily. You’ll sink the price yourself.” That’s the reality of small caps. The market depth is so shallow that even modest trades can send prices spiralling.
And of course, valuations. In heated markets, I’ve seen small-cap stocks trade at multiples far richer than large-cap blue chips. When investors pay more for untested small businesses than for proven industry leaders, you know froth is building. And when that bubble pops, it tends to be swift and unforgiving.
Finally, there’s herd behaviour, the part that makes me most nervous. Money pours in when returns look irresistible, right at the peak. I’ve had friends call me saying, “Everyone in my office has a small-cap fund now. Shouldn’t I buy one too?” By then, more often than not, the easy gains are already gone.
History’s harsh reminders
I’ve lived through two brutal small-cap cycles and both left scars.
In 2007, small caps were all the rage. The euphoria didn’t last. By early 2009, the index had lost three-quarters of its value. A friend who had just entered that year kept telling me, “I thought I was investing, but it feels like I’ve been robbed.” It took him six years to break even.
In 2017, déjà vu. Small caps soared again, funds received massive inflows, and the party seemed endless. By early 2018, stretched valuations finally snapped, and the small-cap rally collapsed under its own weight. My portfolio nosedived. I still recall staring at my account, the number flashing minus 30 per cent. “Should I sell?” I asked myself every day. I didn’t, but the stress was real.
Those episodes taught me: small caps demand either impeccable timing or immense patience.
Who really should invest?
Over time, I’ve realised small caps are not for everyone. They test nerves like no other category.
- If you need money in three to five years, forget it. Small caps demand a long runway, at least seven years or more, for their potential to play out
- If you can’t stomach a 30–40 per cent drawdown, don’t even think about it.
- If you check your portfolio daily, save yourself the heartache.
But if you already have a solid core in large- and flexi-cap funds and you’re willing to set aside a small portion for long-term, high-risk, high-reward bets, then small-cap funds can make sense.
For me, that allocation is never more than 15-20 per cent of my equity portfolio. Enough to feel the upside if it works, not enough to derail my goals if it crashes.
Where we stand now
Today, I see a familiar pattern. Small-cap funds are drawing record inflows. In fact, in just the first eight months of 2025, they pulled in over Rs 36,250 crore, double the Rs 18,600 crore that came in during the same period last year. Valuations, too, are stretched, with some stocks pricier than industry leaders.
That doesn’t mean I’m selling out completely. But it does mean my expectations are restrained. I get the romance of small caps. Who wouldn’t want to discover the next hidden champion? Yet I’ve also seen the other side: portfolios slashed in half, investors shaken by sudden crashes.
For me, the lesson is balance. Handled wisely—modest allocation, patient holding, realistic expectations—small-cap funds can add spice to a portfolio. Handled rashly, they can scorch your wealth.
So the next time someone at the dinner table boasts about their small caps, I’ll smile, nod politely and remind myself that balance, not bravado, is what keeps portfolios intact.
And if you’re wondering what that balance looks like for your goals, Value Research Fund Advisor can help. With curated fund recommendations and a framework rooted in time-tested principles, you can build a portfolio where every fund has a purpose. No noise. No guesswork. Just clarity and confidence.
This article was originally published on September 27, 2025.
Disclaimer: This content is for information only and should not be considered investment advice or a recommendation.
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