Smallcap funds deliver 22% average return in 3 months. Is it time to invest, hold or rebalance?

Small cap funds have emerged as the best-performing equity mutual fund category over the past three months, delivering an average return of 21.89%, according to an analysis by ETMutualFunds.

The strong performance has left investors wondering whether they should stay invested and continue SIPs in small cap funds, or consider rebalancing their portfolios after this performance.

Market expert, Shivam Pathak, CFP and Founder of Asset Elixir told ETMutualFunds that investors shouldn’t react to short-term performance and should continue SIPs if their allocation is aligned with the financial goals.


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However, if the recent rally has significantly increased your small-cap exposure, rebalancing to your target asset allocation would be a prudent approach, Pathak further said.

In contrast, Rajani Tandale, SVP - Mutual Fund and Partner at 1 Finance shared with ETMutualFunds that in the same period earnings actually contracted 9.5% and that’s multiple expansion, not fundamentals, driving returns.

Tandale further said that one should ideally consider a flexicap fund rather than staying concentrated in standalone small-caps, since flexicap managers can shift away from small-caps exactly when data like these signals stretched valuations.

The analysis showed the small cap funds delivered an average return of 21.89% (As of July 5, 2026). There were around 36 small cap funds in the said time period, of which JM Small Cap Fund delivered the highest return of 35.02%. Bank of India Small Cap Fund gave 30.40% return and HDFC Small Cap Fund delivered the lowest return of around 13.31% in the last three months.

Nippon India Small Cap Fund, the largest small cap fund based on assets managed, delivered 19.94% return.

Can momentum continue?

After seeing the performance of small cap funds, Tandale said that the rally is a post-Hormuz relief bounce, not an earnings story, small-cap earnings fell 9.5% (3M) and 12.0% (6M) even as prices rose 24% and 6.2% respectively and this is the opposite pattern of mid-caps, where 17-25% earnings growth has genuinely supported price gains.

She further said that with the small cap 250 trading well above its historical median PE, sustaining this run needs a strong earnings recovery to catch up, absent that, the rally is vulnerable to a correction and realistic expectation: moderation, not continuation, unless earnings turn sharply positive in coming quarters.

Pathak said that the rally has been supported by strong domestic liquidity, improving earnings in select companies, and positive investor sentiment; while the long-term outlook remains positive, investors should not expect such exceptional returns to continue indefinitely, as small caps tend to be cyclical.

Valuations

According to a report India Strategy report, "Beyond the AI Rally: The Great Rotation by Motilal Oswal Financial Services the rally has been supported by strong domestic liquidity, improving earnings in select companies, and positive investor sentiment.

While the long-term outlook remains positive, investors should not expect such exceptional returns to continue indefinitely, as small caps tend to be cyclical, the report further said.

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On valuations, Tandale said that small-cap (Nifty Smallcap 250) is least compelling, earnings contracting (-9.5% to -12%) while prices rallied 24% in 3 months, leaving valuations above median and highly sensitive to any disappointment.

So are the current valuations a good point for first time investors to start SIP or should they stagger their investments? Pathak said that given the recent sharp rally, a staggered approach is preferable and investors can start with SIPs or use an STP from a liquid fund to gradually build exposure, reducing the risk of investing a large amount at elevated valuations.

Tandale said that given earnings are contracting while prices have surged, this is a weak entry point for a dedicated small-cap bet, a first-timer risks buying into multiple expansions with no earnings support.

She further said that STP is the safer route for lump sums; SIP is fine for long horizons (7-10 years) since it averages through the volatility but the stronger recommendation now: route new small-cap exposure through a flexicap fund, not a standalone small-cap fund, flexicap can stay underweight small-caps until earnings actually validate current valuations, while a dedicated small-cap fund has no such flexibility.

The analysis by ETMutualFunds further showed that small cap funds delivered the highest return in the last 10 years. These funds delivered an average return of 16.93% with Nippon India Small Cap Fund emerging as the top performer with 20.69% CAGR, followed by Quant Small Cap Fund which gave 20.04% CAGR.

In the other longer horizons say three years and five years, though the category didn’t emerge as the top performer but delivered an average return of 17.81% and 16.89% respectively.

Allocation in smallcaps and what to expect?

Tandale said that one should keep standalone small-cap exposure minimal rather than adding fresh money here and the more sensible route for small-cap exposure right now is through a flexicap fund, letting the manager increase small-cap weight only once earnings growth actually catches up to the re-rating, rather than holding a fixed, valuation-agnostic small-cap allocation in a segment where the fundamentals currently don't support the price action.

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Pathak said that small-cap funds should typically form 10-20% of an equity portfolio, depending on an investor’s risk profile and investment horizon and the long-term outlook remains positive, but investors should be prepared for higher volatility and periodic corrections.

(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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