Small-cap funds are booming again. Are investors repeating the 2024 mistake?

In July, small-cap funds received a record Rs 7,768 crore, up nearly 39% from Rs 5,602 crore in June. It was the highest monthly inflow into the category so far. At the same time, large-cap funds saw an outflow of Rs 1,322 crore, their first monthly outflow in 30 months.

The renewed rush into small caps comes after a strong recovery in the segment. Data shows the Nifty Smallcap 250 gained 14.83% in six months and 9% in one year as of August 13, 2026. The Nifty Midcap 150 gained 7.44% and 10.89% over the same periods, while the Nifty 50 returned -4.55% and -1%, respectively.

The performance gap is also visible at the fund level. Value Research data shows small-cap funds have delivered returns of more than 33% in the best case over one year, while the median return across 59 small-cap funds is around 16%.

This is exactly what makes the current situation worth watching.

Why did SEBI raise the alarm in 2024?

The last big small-cap rush had already prompted regulatory concerns.

In 2024, SEBI asked mutual funds to carry out liquidity stress tests for small-cap and mid-cap schemes. The concern was not simply that small-cap stocks had become expensive. The bigger worry was what would happen if a large number of investors tried to withdraw their money at the same time.

Small-cap stocks generally trade in lower volumes than large companies. So if a fund faces heavy redemptions during a market fall, it may not be able to sell all its holdings quickly without putting pressure on prices.

The concern was therefore straightforward: could a fund raise cash quickly enough if investors suddenly rushed for the exit?

The stress tests were designed to estimate how many days a scheme could take to liquidate a specified portion of its portfolio under stressed conditions. The exercise was intended to give investors a better understanding of liquidity risk and reduce the advantage enjoyed by investors who exit first during a panic.

The risk can become particularly uncomfortable in a falling market:

Heavy inflows → bigger AUM → greater exposure to small and relatively less-liquid stocks → sudden redemptions → forced selling → falling prices → more redemptions.

That is why SEBI’s earlier concern about a build-up of “froth” in the small- and mid-cap segments mattered.

The risk has not disappeared — but liquidity has improved

There is, however, an important difference between 2024 and now.

The latest stress-test numbers suggest that liquidity conditions have improved across most of the large small-cap schemes.

For instance, Nippon India Small Cap Fund, the largest small-cap scheme by AUM, could liquidate 50% of its portfolio in 26 days in June 2026, compared with 38 days in January.

The improvement is not limited to Nippon India. HDFC Small Cap Fund’s 50% liquidation period fell from 75 days in January to 46 days in June, while Quant Small Cap Fund improved from 102 days to 45 days.

Here is how the top 10 schemes ranked by AUM have moved:

Scheme	AUM (Rs crore)	Jun-26	May-26	Apr-26	Mar-26	Feb-26	Jan-26
Nippon India Small Cap Fund	78,400.06	26	29	29	31	44	38
HDFC Small Cap Fund	40,427.50	46	54	51	64	66	75
SBI Small Cap Fund	40,165.10	48	59	65	59	71	73
Quant Small Cap Fund	33,734.51	45	54	65	75	87	102
Axis Small Cap Fund	29,395.64	16	18	23	26	23	25
Bandhan Small Cap Fund	28,531.93	21	17	14	16	16	17
DSP Small Cap Fund	19,642.62	32	37	52	48	47	54
Kotak Small Cap Fund	18,688.99	27	29	39	39	39	37
HSBC Small Cap Fund	17,829.70	8	10	10	11	10	12
Franklin India Small Cap Fund	14,336.26	11	12	11	14	13	13

(Stress-test results indicate estimated days required to liquidate 50% of the portfolio under the prescribed stressed conditions. Data provided by Sadiya Khan, Chief Investment Solution Officer, Mirae Asset Sharekhan.)

The numbers show why investors should not look at the category as one homogeneous bucket. While some of the largest schemes may take several weeks to liquidate 50% of their portfolios under the stress-test assumptions, smaller or more liquid portfolios can show much shorter timelines.

Sadiya Khan, Chief Investment Solution Officer, Mirae Asset Sharekhan, says the latest stress-test data shows an improvement in liquidity across major small-cap schemes compared with six months ago.

But she also cautions that a sudden increase in redemption pressure could again hurt liquidity. Investors, she says, should have a minimum five-year investment horizon, avoid making decisions based on short-term market sentiment or panic and check liquidity metrics and stress-test results before investing.

Don’t read the stress-test number in isolation

There is another important point investors need to understand.

A stress-test number is not a prediction of what will happen to your fund during the next market crash. Nor does it mean the fund manager will simply sell 50% of the portfolio in that number of days when investors actually redeem.

Amitabh Lara, Executive Director, Anand Rathi Wealth Limited, points out that fund managers would generally use available cash first and then sell more liquid holdings before selling less-liquid small-cap stocks.

The numbers can also be higher for funds with very large AUM because they have a larger rupee amount invested in small caps. Since small-cap schemes are required to maintain at least 65% in small caps, a larger fund naturally has a larger pool of assets to liquidate.

Therefore, Lara says investors should not view the stress-test number in isolation, because actual liquidity management can be better than the headline number suggests.

This distinction is important when comparing funds. A 50-day liquidation number may look alarming on paper, but it does not mean that investors would have to wait 50 days to get their redemption money.

So why are investors rushing back into small caps?

One obvious answer is performance.

The Nifty Smallcap 250 had corrected around 23% between September 2024 and March 2026, according to Lara. That correction brought valuations to more attractive levels and created a better entry opportunity.

Since then, the index has recovered, gaining around 10% so far this year, according to Lara.

Khan also points to the broader investment opportunity. The Nifty Smallcap 250 has 250 stocks compared with 50 in the Nifty 50. This gives active fund managers a much larger universe from which to pick stocks and potentially generate alpha.

But there is a trade-off.

The greater potential for outperformance comes with higher volatility and higher risk. Khan says improving domestic fundamentals and easing global uncertainties could continue to support sentiment, but investors should keep small caps as part of a diversified portfolio rather than increase allocations simply because the category has delivered higher returns.

The AUM story is adding to the concern

The money flowing into the category is not a one-month phenomenon either.

Small-cap fund AUM rose from Rs 3,55,901.80 crore on July 31, 2025, to Rs 4,41,099.91 crore on July 31, 2026 — an increase of about 24%.

Over the same period, the total mutual fund industry’s AUM rose from Rs 75,35,970.68 crore to Rs 85,75,656.52 crore, a growth of nearly 14%.

In other words, small-cap fund AUM has grown at about 1.74 times the pace of the overall mutual fund industry.

Yet small-cap funds still account for only about 5.1% of the industry’s total AUM.

The monthly flow trend also shows how quickly investor interest has returned:

Category	Jul-26	Jun-26	May-26	Apr-26	Mar-26	Feb-26	Jan-26
Small-cap Funds	7,768	5,602	4,946	6,886	6,264	3,881	2,942
Mid-cap Funds	6,192	6,090	4,385	6,551	6,064	4,003	3,185
Flexi-cap Funds	4,709	5,231	5,176	10,148	10,054	6,925	7,672
Large & Mid-cap Funds	3,425	4,321	3,278	4,490	5,307	3,138	3,182
Multi-cap Funds	3,227	3,070	2,291	3,806	2,982	1,934	1,995
Sectoral/Thematic Funds	1,328	1,469	648	1,949	2,699	2,987	1,043
Focused Funds	642	1,118	830	1,195	2,425	901	1,557
Value/Contra Funds	-145	687	510	1,478	2,156	727	993
Dividend Yield Funds	-169	-49	-97	-21	-59	21	48
ELSS Funds	-959	-634	-651	-568	-437	-650	-594
Large-cap Funds	-1,322	2,067	1,593	2,525	2,998	2,112	2,005
Total	24,697	28,973	22,908	38,440	40,450	25,978	24,029

(Source: data provided by Sadiya Khan, Mirae Asset Sharekhan.)

The flow pattern tells an interesting story. Small caps have remained among the strongest categories for several months, even as large-cap funds have struggled to attract money.

Is this just return chasing again?

This is where the two experts have a slightly different emphasis.

Khan says the renewed interest is partly explained by the segment’s superior performance and the wider stock-selection opportunity available to small-cap fund managers. But she warns against increasing allocations solely in pursuit of higher returns.

Lara is more direct about the behavioural risk.

He calls it recency bias — investors see small caps doing well and assume that the recent performance will continue.

There is a reason to be careful here. During the 2023-24 small-cap rally, the Nifty Smallcap 250 rose around 86%, while small-cap funds ranked among the top two categories for net inflows in 11 of 12 months in 2023.

The pattern is familiar: returns attract money, and rising inflows can reinforce investor confidence.

But what worked yesterday does not automatically work tomorrow.

What should an existing SIP investor do?

This is perhaps the most practical question for investors who are already invested.

Khan does not recommend stopping a small-cap SIP simply because the market corrects.

SIPs, she points out, work particularly well through volatility because the investor buys more units when prices fall and fewer when prices rise. Instead of making sudden changes, investors should review their asset allocation at least once a year and their portfolios at least once every six months.

For fresh investments, however, she sees merit in staggering the money during volatile periods, either by investing gradually or using a systematic transfer plan from liquid funds into equity funds.

The bigger point is allocation.

Small caps, Khan says, require a minimum five-year horizon and a higher risk appetite. They should not be the first choice for an equity investor, and investors should keep an eye on how much of their overall portfolio is already concentrated in small caps.

Lara makes a similar argument from a different angle. Small-cap corrections, he says, are a normal part of the market cycle. Over the last 25 years, small caps have seen average declines of around 25% every year, with most corrections lasting only three to four months and the market typically recovering to its previous peak within 12 to 18 months.

For him, the bigger danger is not necessarily a correction itself. It is changing an investment strategy every time the market moves.

The bigger lesson from SEBI’s stress test

The latest numbers should give investors some comfort, but not complacency.

Liquidity has improved. Some of the largest funds can now liquidate 50% of their portfolios in fewer days than they could six months ago. At the same time, strong domestic flows are helping the market absorb transactions.

But that does not mean the original risk SEBI was worried about has vanished.

Small-cap funds are again receiving record money, AUM is growing much faster than the overall mutual fund industry and investors are once again being drawn by superior recent performance.

That makes one lesson from the 2024 episode particularly relevant: liquidity risk can look manageable when markets are functioning normally and trading volumes are healthy. It is during a sharp fall, when everyone wants to sell at the same time, that the real test begins.

And investors should remember that a stress-test number is only one part of the risk assessment. Valuation, portfolio concentration, investment horizon, asset allocation and the ability to tolerate sharp losses matter just as much.

As Lara puts it, the biggest mistake investors can make is chasing past performance and deviating from their long-term strategy because of market ups and downs.

For investors already running a small-cap SIP with a long-term goal, that means a correction need not automatically be a reason to exit. For someone considering a large fresh allocation simply because small caps have been doing well, however, the current enthusiasm is a good reason to pause and check whether the risk actually fits the portfolio.

The stress test may have become less stressful. But that does not mean small-cap investing has become risk-free.

Disclaimer: This article is for informational purposes only and should not be construed as investment, financial, tax, or legal advice. Any illustrations, examples, or return projections used in this article are for explanatory purposes only and do not guarantee actual investment outcomes. The views and opinions expressed by experts quoted in this article are their own and should not be considered investment recommendations. Readers should consult a qualified professional before making any financial decisions. 

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