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Pallav Agarwal, Certified Financial Planner at Bhava Services LLP, told ETMutualFunds that earnings of small-cap stocks jumped to around 25% in the last quarter on a year-on-year basis. He added that the earnings revival, along with inexpensive valuations after an 18-month correction, triggered the sharp rebound.
Agarwal further said that investors should not increase allocation at this stage after a 17% run-up, and profits should be booked in line with asset allocation.
Another expert, Nilesh D Naik, Head of PhonePe Mutual Funds, said that if we look at the correction from the peak to the recent bottom in March, small-cap funds saw a sharper decline compared to their large-cap counterparts.
Naik further noted that as on 31st March 2026, the Nifty Smallcap 250 Index was down about 23% from its peak, whereas the Nifty 100 Index was down around 15%. During such corrections, even quality stocks with strong fundamentals tend to decline, but they typically bounce back as conditions normalize.
Consequently, as the market recovered over the past three months, many active small cap funds focusing on relatively stronger fundamentals have been able to deliver strong performance, he added further.
Beginning of a sustained rally or just a rebound?
In the last three months, smallcap funds have outperformed all equity mutual fund categories, including international funds, which have been the toppers across different horizons. International funds delivered an average return of 14.33% over the same period.
The other three categories that delivered double-digit average returns were infrastructure funds with 12.19%, pharma & healthcare funds with 11.17%, and midcap funds with 10.86%. The remaining 16 categories posted average returns ranging from 3.68% to 9.98% in the last three months.
The recent rally has reignited interest in small-cap funds, but experts remain cautious about declaring the start of a long-term bull run.
Naik said that over the past three years, funds in the small-cap category have outperformed large-cap funds by an average of 5-6% on an annualised basis, though the magnitude of outperformance has reduced compared to a few years ago. He added that the current rally looks more like a rebound after the correction, especially given the earnings growth trends in the last quarter of FY26.
Agarwal said that the BSE Smallcap Index has already climbed nearly 19% from its March 2026 lows, and the rally has been driven more by liquidity than strong fundamentals. He added that it looks like a mean-reversion bounce for now, and the rally can sustain only if earnings growth remains robust in the coming quarters.
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Better placed than large and flexi-caps?
According to Equity View-June 2026 by Tata Mutual Fund, the risk-reward is more in favour of largecaps, with selective exposure to mid- and smallcap stocks in favoured sectors. The Nifty Smallcap 100 one-year forward P/E remains at 22.6, higher than its long-term average of 16.9x.
The equity view also highlighted that small caps are trading at elevated valuations compared to large caps and global peers. Current valuation metrics suggest greater relative attractiveness for large caps, as they offer a better risk-reward balance.
With small-cap valuations rising after the recent rally, Agarwal said SIPs are clearly better than lump-sum investments at these levels. He added that any investment in pure small-cap funds should ideally be made only through long-term SIPs of 7-8 years.
He further said that flexicap funds currently offer better risk-adjusted returns, with quality small caps as part of their allocation and a minimum time horizon of at least five years.
Naik also favours the SIP route. He said that in the current environment, SIPs would be a better option for investing in smallcap funds, given prevailing valuations and earnings growth trends.
Performance of small caps
In the last three months, there were 35 smallcap funds, of which Bank of India Small Cap Fund delivered the highest return of around 27.24%. Nippon India Small Cap Fund, the largest fund in the category, delivered a 15.48% return. HDFC Small Cap Fund posted the lowest return of 8.97% over the same period.
Over longer horizons such as six months, one year, three years and five years, smallcap funds have consistently been among the top five or six best-performing categories across all equity mutual fund categories.
Naik said that smallcap fund performance tends to be more cyclical compared to large- or mid-cap counterparts. As such, they are better suited as tactical allocations in portfolios, given their higher volatility and the need for more active management.
He further added that given current valuations and earnings growth trends in small caps, investors may need to moderate return expectations from this category in the short- to medium-term.
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To this, Agarwal said the valuation of the small-cap index looks a bit stretched. He added that for this space to repeat its stellar performance, high earnings growth must sustain. However, with crude oil prices remaining elevated in the current quarter for an extended period, along with supply chain disruptions due to a shipping crisis, margins of companies could come under pressure. He further said that easy returns from small caps may be behind us, and the outlook remains “optimistically cautious.”
(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)
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