India’s small-cap segment is currently undergoing a significant transformation, challenging long-held assumptions about the category. Despite a noticeable softening in one-year returns, investor enthusiasm—measured by massive inflows into small-cap mutual funds—shows no signs of slowing down. This paradox highlights a fundamental shift in both the market’s size and investor expectations.

Today’s “Small” is Yesterday’s “Mid-Cap”

The most striking change is the sheer scale of companies now classified as small-caps. Market capitalization has expanded so dramatically that many companies once considered mid-caps have been reclassified into the small-cap universe.

For context, the company ranked 251st in India by market capitalization now boasts a valuation exceeding ₹30,000 crore. Even the 750th ranked company is sizable, valued at approximately ₹4,900 crore. This reality contradicts the common retail investor perception, who often associate the term “small-cap” with fledgling or niche businesses.

This revaluation means that several well-known brands and established firms with strong business models are officially categorized as small-caps by Asset Management Companies (AMCs). This disparity often leads to a “perception mismatch” where investors view these established names as mid-caps, while they fall firmly into the small-cap mutual fund mandate.

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Fund Strategy: Quality, Liquidity, and Diversification

Contrary to the belief that small-cap funds are risky, concentrated bets on tiny firms, recent data suggests they are operating with a structured and risk-aware approach:

• Diversified Exposure: The vast majority of holdings (over 80%) in small-cap funds are concentrated in the top 750 companies by market cap, including a significant portion in the “true” small-cap zone (ranks 251–750).
• The Mid/Large-Cap Buffer: To manage volatility and ensure liquidity, these funds strategically allocate nearly 20% of their portfolio to larger, more stable large- and mid-cap stocks (top 250 companies).
• Cash is King: Funds maintain an average of around 7% in cash as a crucial liquidity buffer, enabling them to meet redemption requests without being forced to sell assets at unfavorable prices.
• Avoiding the “Micro” Zone: Fund managers generally avoid the genuine micro-cap segment (companies valued around ₹1,000 crore) due to high liquidity risks, further differentiating AMC-managed portfolios from speculative retail investments.

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Inflows Surge Despite Short-Term Performance Dip

The small-cap segment has seen a significant cooling in performance, with the one-year average return dropping considerably (around 3% as of October 2025). Yet, this moderation in performance has not deterred investors.

The period between April and October 2025 saw record-breaking inflows of over ₹30,500 crore into small-cap funds, representing a 58% surge compared to the same period in the previous year. This flow demonstrates robust investor conviction in the segment’s long-term potential, suggesting that current valuations are being viewed as a temporary entry point rather than a red flag.

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Investor Takeaway: Patience is the Priciest Asset

Experts maintain that small-caps offer the highest potential for long-term alpha generation due to their wider sector spread and higher growth potential. However, they are also inherently more volatile in the short term.

To successfully harness this potential, investors must adopt a disciplined approach:

• Mandatory Long Horizon: Treat small-cap investing as a minimum five-year commitment.
• Embrace Volatility: Expect and tolerate heavy short-term price swings; trying to time the market is highly discouraged.
• Focus on Quality: Prioritize funds with robust portfolio construction, a strong track record, and adequate liquidity buffers.

Ultimately, the small-cap market is a playground for patient capital. While the short term may bring turbulence, staying the course remains the core strategy for meaningful wealth creation in this dynamic category.