Equity market performance over the last 18 months has been painful. Although the Nifty 50 and Nifty Midcap 100 delivered a positive return of 7.9% and 5.6% in the last year, small-cap stocks have lagged.
Nifty Small-cap 250 has delivered a negative return of 6.4% during the period. The drawdown at the index level is not as high, but market breadth paints a different picture. Nearly 80% of small-cap index companies have seen corrections of over 20% from their all-time highs.
As per The Economic Times, 63 companies are trading below 50% from their highs, 51 stocks (40-50%), 38 stocks (30-40%), 50 stocks (20-40%), and 48 stocks (0-20%).
As of 19 January 2026, only 20% of small-cap stocks are trading above their 40-week moving averages, according to Chartlink.
Amid this weakness, this editorial examines whether now is the right time to invest in small-cap funds via a lump sum.
Let’s start with valuations…
Valuations Ran Ahead of Earnings
Small-cap stocks delivered a multibagger return during the 2023 to 2024 rally, mainly through price-to-earnings (PE) expansion, as earnings growth was strong.
For example, the PE ratio of the Nifty Small-cap 250 index rose from a low of around 17 times in April 2023 to 35 times by December 2024.
The rally paused after that phase, as earnings growth moderated and elevated valuations left little room for further re-rating.
That said, many stocks delivered multibagger returns during that rally, as has historically been the case.
In every bull market, smaller firms deliver stellar performance, generating significant “alpha” (excess returns) relative to large-cap stocks.
For instance, in certain periods, smallcaps delivered a CAGR of 74% compared to 49% for largecaps, or 37% versus 26% in others, as per DSP Netra January 2026 edition.
Smallcaps Outperformance in Upcycle
Source: DSP Netra January 2026 Edition
Smallcaps Have Given up Most of Their Alpha
However, this outperformance is not permanent.
During downcycles, they tend to lose almost all the alpha generated during the upcycle.
Smallcaps have Given up Most of Their Alpha
Source: DSP Netra January 2026 Edition
Volatility Defines the Smallcap Cycle
This phenomenon is driven by higher volatility in the small-cap segment, which experiences larger drawdowns and crashes during bear markets than large-cap stocks do.
This is why investors should prioritise a margin of safety and avoid chasing recent outperformance. When smallcaps underperform largecaps, it may be a good time to take an aggressive approach towards them.
In simple terms, a sharp correction in small-cap stocks can open up an opportunity to take a contrarian view, as fear-driven selling often pushes prices well below the underlying business value.
Fund Flows Drive Smallcap Rallies
Most rallies in small-cap stocks are driven by fund flows.
Historically, there is a strong correlation between past performance and inflows.
Fund Flows Move Smallcaps
Source: DSP Netra January 2026 Edition
Flows into small-cap mutual funds rise sharply due to strong past performance, as investors chase higher returns. However, flows decline when recent returns flatline or turn negative. This was the case during the robust returns of 2023-2024.
As per the Association of Mutual Funds of India (AMFI), inflows into small-cap funds surged to Rs 52.3 billion (bn) in 2025, up from just Rs 13.9 bn in 2020 and Rs 342.2 bn in 2024.
Trend Inflows into Smallcap Funds
| Year | 2020 | 2021 | 2022 | 2023 | 2024 | 2025 |
| Inflows (Rs bn) | 13.6 | 38.0 | 197.6 | 410.4 | 342.2 | 523.2 |
| % Share in total inflow | 15.2 | 3.9 | 12.3 | 25.4 | 8.7 | 14.9 |
| Source: AMFI | ||||||
However, as a percentage of total inflows, it remains at 14.9%, compared with 15.2% in 2020.
In November 2025, total inflows into small-cap funds increased by 26.8% compared to October.
In October, inflows decreased by 20% compared to September, which saw a 13% decrease, and August saw a 23% decrease.
Valuations Have Moderated
Although inflows have moderated in recent months, the absolute level of money entering small-cap funds remains elevated.
This steady domestic participation has helped keep small-cap indices relatively resilient, even as many individual stocks have seen much sharper corrections beneath the surface.
At the same time, strong domestic investor support has absorbed over Rs 3 trillion of net selling by foreign investors in 2025, cushioning the indices from deeper declines.
This is why a slowdown in foreign investor selling is crucial to the stability and recovery of small-cap stocks.
That can only happen when earnings growth picks up, allowing valuations to normalise even if prices remain range bound.
The valuation of the Nifty Small-cap 250 index has fallen to 26.7 times (as of 23 January 2026) and is at a discount to its 10-year median multiple of 29.9 times.
So, valuations have moderated, but it’s not at a level of broad based rally.
Earnings Growth Remains Narrow
According to stocks, the Nifty-500’s aggregate earnings registered the strongest earnings growth in five quarters, with earnings increasing by 15% year-on-year in Q2 FY26.
However, revenue increased by only 8%, indicating that margin expansion led the earnings growth.
Earnings for the Small-Cap 250 index increased even more significantly, by 37%. This shows that earnings are higher, but revenues are not.
With valuations still elevated and last year’s base relatively low, the trajectory of earnings growth in Q3 FY26 could be key in determining whether the recent correction stabilises or extends further.
A near-term pullback could be on the horizon. However, for any sustained recovery, foreign investors need to turn net buyers, and earnings growth must show a clear pickup, providing fundamental support to current valuations.
How Should Investors Approach Smallcap Funds Now?
Small-cap funds are best suited for investors with a long-term investment horizon of 5-7 years or more, allowing enough time to ride through volatility and earnings cycles.
These funds are fundamentally different from large and mid-cap funds. They operate in a segment where liquidity is thin price discovery is slow, and volatility is structurally high. They outperform in upcycles and give all almost all the returns in downcycles.
This makes the mode of entry as important as the investment decision itself. Broadly, investors have two routes: lump sum investing and systematic investing (SIP). Both have merits, but they serve different risk profiles and market conditions.
Why Lumpsum Investing Carries Higher Risk
A lump-sum investment can work well when valuations are deeply attractive, and earnings visibility is improving. If markets rebound sharply from oversold levels, early capital deployment captures a larger part of the upside.
It also simplifies execution, especially for investors holding idle cash or reallocating from other asset classes. But this requires precise timing of the market, which is next to impossible.
Smallcap funds are highly sensitive to short-term market swings, like in recent days. A lump-sum investment made just before another leg of a correction can lead to prolonged drawdowns. The timing risk is materially high.
Unlike largecaps, recoveries in smallcaps are often uneven and stock specific, which can delay returns. Historically, smallcaps have given no returns for years.
Volatility can also test investor patience, increasing the risk of making an exit at the wrong time.
Given current conditions, where valuations have moderated, but earnings growth confirmation is still ‘work in progress’, a single-shot lump-sum exposure exposes investors to unnecessary timing risk.
A better approach could be a staggered investment in parts. Spreading the investment across multiple tranches allows investors to benefit from cost averaging. This reduces the risk of entering at an unfavourable market level while still being positioned for a recovery.
SIPs Offer Better Risk Control in Volatile Markets
Systematic Investment Plans (SIPs) offer a more balanced way to participate without overexposing capital to near-term risks, regardless of market conditions.
SIPs average out purchase costs across market cycles, which is particularly valuable in a volatile segment like small caps. They reduce behavioural risk by removing the pressure of timing the market.
As a result, SIP investors may deploy capital gradually, missing part of the initial upside.
Returns may appear muted in the early phase compared to a well-timed lump sum investment. However, over the long term, this monthly investment is known for building wealth.
SIPs remain better suited for most investors in smallcap funds, especially when visibility is limited.
A Staggered Approach Works Best
For investors keen to deploy capital now, a middle path often works best.
Instead of investing the entire amount at once, capital can be deployed through a staggered lumpsum approach, splitting investments into multiple tranches over several months.
This reduces timing risk while still allowing participation if markets stabilise sooner than expected.
Alongside this, continuing or initiating SIPs ensures disciplined participation across market phases, particularly if volatility persists.
However, given their higher volatility and drawdowns, smallcap funds are not suitable for investors with low risk tolerance or short-term liquidity needs.
Time in the Market is More Important Than Timing the Market
Small-cap funds can play an important role in long-term wealth creation, but they demand patience, discipline, and the right entry framework.
While corrections create opportunities, they do not eliminate risk. In the current environment, investors are well served by spreading investments over time rather than attempting to time a single entry point.
A staggered lump-sum approach, supplemented with SIPs, allows investors to stay invested. This helps manage volatility and aligns investments with a gradual earnings recovery. This approach better suited to the realities of small-cap stocks.
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