Small-cap funds have long enjoyed a special place among investors. The logic seems straightforward: invest in smaller companies today and benefit from their growth tomorrow.
But is the promise of higher returns always worth the extra risk?
A new report from Share.Market by PhonePe suggests investors may want to have a closer look before assuming that small-cap funds are the best route to long-term wealth creation. While small caps have delivered better returns than large caps over the past two decades, the difference may be smaller than many investors expect.
The findings come from the latest CRISP Scorecard, which analysed 20 years of data comparing the Nifty Small Cap 250 Total Return Index with the Nifty 100 Total Return Index.
The study found that the Nifty Small Cap 250 generated annualised returns of 12.54%, while the Nifty 100 TRI delivered 11.72%.
At first glance, small caps did come out ahead. However, the outperformance was just 0.82 percentage points annually.
For many investors, that raises an important question: is the additional return enough to justify the significantly higher risk?
According to the report, earning that extra return was far from easy.
Small-cap investments experienced annualised volatility of 28.81%, compared with 21.06% for large-cap stocks. They also suffered much deeper declines during difficult market periods.
In simple terms, investors had to endure far greater swings in portfolio value for a relatively modest increase in returns.
The report describes this as a risk-reward paradox, where the extra gains may not fully compensate investors for the additional uncertainty.
One of the strongest messages from the study is that small-cap performance is highly cyclical.
During strong bull markets, small caps can significantly outperform larger companies. Between 2014 and 2017, for example, they generated exceptional returns.
However, the picture changes during market corrections. Between 2018 and 2020, small-cap stocks struggled and underperformed.
The report found that over rolling three-year periods, small-cap outperformance ranged from a strong 20.52% during favourable market phases to underperformance of 17.16% during weaker periods.
This suggests that timing can play a bigger role in small-cap investing than many people realise.
Nilesh D Naik, Head of PhonePe Mutual Funds, believes investors should not automatically assume that holding small-cap investments indefinitely will deliver the best results.
“Contrary to popular belief, a simple buy-and-hold strategy in small caps may not optimally compensate for the risk. The latest CRISP MF Scorecard suggests a strong negative correlation between past 3-year outperformance and future 3-year outperformance vs the large caps, favoring a tactical approach based on relative valuations.”
His comments indicate that valuation levels and market cycles may be just as important as investment tenure when it comes to generating returns from small-cap funds.
The report notes that after a period of correction, the gap between small-cap and large-cap performance has narrowed.
As valuations have become more reasonable compared with previous peaks, the study sees a potential 12-to-18-month opportunity for aggressive investors willing to take a tactical approach to small-cap investing.
However, experts caution against chasing returns blindly.
The scorecard recommends focusing on funds that have demonstrated consistent performance and follow a disciplined investment style centred on quality and value.
Meanwhile, small-cap funds have historically delivered slightly higher returns than large-cap funds, but the journey has been far more volatile.
The latest study suggests that investors should not focus only on returns. Understanding the risks, choosing funds carefully and recognising that small caps move in cycles may be equally important.
For investors seeking long-term growth, small-cap funds can still play a role. But the report suggests that patience alone may not be enough — timing, valuations and fund selection matter too.