Should You Invest in Mid-Cap and Small-Cap Funds Amidst Volatile Equity Markets?

While the allure of higher returns has attracted many, the question remains: should you invest in mid-cap mutual funds and small-cap funds amidst volatile equity markets?

This article dives deep into the dynamics of mid-cap and small-cap funds, their performance, risks, and considerations for investors looking to navigate the choppy waters of today's market.

[Read: Best Mutual Funds to Invest in 2025]

Mid-cap and small-cap stocks have been the standout performers in the year 2024, with indices in these categories surging to all-time highs. This rally has been driven by a mix of retail investor enthusiasm and targeted investments in emerging growth sectors. However, elevated valuations in these segments have raised concerns about sustainability, prompting investors to tread cautiously amidst market corrections.

All three indices exhibit a general upward trend, with periods of volatility and corrections. Notably, Nifty Smallcap 250 has demonstrated the most significant growth over the period, surpassing the returns of both Nifty 100 and Nifty Midcap 150, suggesting that smaller-cap companies have outperformed their larger counterparts during this timeframe.

As the Indian economy has experienced consistent growth during this period, the mid and small cap companies have likely benefited from increased consumer spending and economic activity. The graph underscores the potential of mid and small-cap stocks for generating substantial returns. However, investors considering investing in small-cap equities should carefully assess their risk tolerance and investment horizon.

[Read: Mutual Fund Returns in 2025: Will Small Cap Fund Dominance Sustain?]

Volatility has been a defining feature of the market in 2024, with global headwinds such as inflationary pressures and interest rate hikes creating an unpredictable environment. Domestically, policy reforms and government spending in key areas like infrastructure and manufacturing have provided a much-needed boost. Yet, the interplay of high valuations and periodic corrections has kept market participants on their toes.

Rising Inflows into Mid and Small Cap Mutual Funds

Over the past few years, there has been a marked increase in inflows into mid- and small-cap funds, driven by investors' desire to tap into the growth potential of smaller companies. These segments of the market typically offer higher growth opportunities compared to their large-cap counterparts, as they tend to be more nimble and benefit disproportionately from economic expansions.

The graph reveals a dynamic investment landscape with varying levels of investor interest across different fund categories throughout the year. notably, mid and small cap funds witnessed the most significant inflows, particularly in the latter half of the year 2024, suggesting a growing appetite for riskier, yet potentially higher-reward investments, while large cap funds saw a more moderate level of investment activity.

[Read: 3 Best Mid Cap Funds for 2025 - Top Performing Mid Cap Mutual Funds in India]

The mid-cap and small-cap segments have been standout performers in the Indian equity market in 2024. The NIFTY Midcap 150 and NIFTY Smallcap 250 indices have delivered impressive year-to-date returns of approximately 18% and 25%, respectively, as of December 2024. This outperformance has been driven by robust domestic inflows, strong corporate earnings, and increased investor interest in emerging growth sectors such as renewable energy, healthcare, and technology.

Mid and small cap funds are seen as a means to capitalize on untapped opportunities in emerging sectors, which can provide more dynamic growth compared to the more mature, slower-growing large-cap stocks. Additionally, the relative undervaluation of many mid- and small-cap stocks compared to their large-cap peers makes them an attractive proposition, especially for active fund managers who believe these companies are poised for long-term growth.

Market volatility has also played a role in driving the surge in mid- and small-cap inflows. While heightened volatility often leads to risk aversion in the broader market, it can also provide opportunities for savvy investors to buy into companies that are undervalued or positioned to perform well despite market uncertainty.

[Read: 3 Best Small Cap Funds for 2025 - Top Performing Small Cap Mutual Funds in India]

Retail investor enthusiasm has been a key driver, notably, small-cap funds alone attracted over Rs 30,000 crore in total in 2024, a testament to their appeal among investors seeking high-growth opportunities. The increasing folio count in these categories' underscores growing confidence, even amidst broader market volatility.

However, elevated valuations in both segments have raised concerns about sustainability. Price-to-earnings (P/E) ratios for mid-cap and small-cap indices have reached historically high levels, hovering above 40x in some cases, signalling caution. Periodic corrections have also highlighted the risks associated with these volatile segments, as their sensitivity to macroeconomic factors and external shocks remains high.

The future outlook for mid-cap and small-cap funds is cautiously optimistic. With India's GDP expected to grow at 6.5%-7% in FY 2025-26, sectors represented in under the mid and small cap indices are poised for expansion. Government initiatives in infrastructure, manufacturing, and green energy are likely to provide tailwinds. However, investors are advised to adopt a staggered approach, focusing on quality funds with proven track records, to mitigate risks associated with overvaluation and market volatility.

Choose Your Mid and Small Cap Mutual Funds Wisely

In the current market scenario, characterized by heightened volatility and uncertainty, investors are increasingly cautious about the risks associated with mid and small-cap funds. These funds, traditionally known for their high-growth potential, are also more susceptible to market fluctuations compared to large-cap funds.

While the market volatility presents opportunities, it is crucial to understand that mid and small-cap stocks tend to experience more pronounced price swings. As a result, investors should evaluate their risk tolerance and investment horizon before committing to these funds.

Given that, mid and small-cap funds can be an attractive addition to a diversified portfolio, but they require a strategic approach. While the short-term outlook may seem uncertain due to market fluctuations, these funds have the potential to outperform large-caps over the long term.

Historically, mid and small-cap stocks have provided higher returns, particularly during periods of economic recovery and growth. However, this performance comes with a higher degree of risk, making it essential for investors to maintain a long-term focus to ride out the inevitable ups and downs in the short run.

[Read: Adding New Mutual Funds for Better Gains? Here's Why It Could Be a Risky Move]

Investors considering mid and small-cap funds must recognize the inherent volatility these funds bring. While they can outperform large-cap funds in a strong market, their performance tends to be more erratic during downturns or periods of uncertainty. For risk-averse investors, these funds may not be suitable for the core part of their portfolio. However, they could play a strategic role within a diversified approach. Adopting a Core & Satellite Strategy may help balance the potential rewards with the risks.

The Core & Satellite strategy ensures that your portfolio is well-balanced, where the core investments provide stability and protection during market volatility. These may include blue-chip stocks or large-cap mutual funds that tend to be more resilient in uncertain market conditions.

On the other hand, small and mid-cap funds, placed in the satellite portion, can offer higher growth potential, benefiting from long-term market trends that may outperform once market conditions stabilize. The key is to avoid overexposure to these riskier assets and ensure that the allocation aligns with your risk appetite.

As an investor, it's important to remain patient and focused on long-term objectives, especially when navigating mid and small-cap funds during volatile times. A carefully crafted portfolio, with appropriate diversification across asset classes and fund types, can not only help weather the storm but also position you to capitalize on future market recoveries.

Keep in mind that market cycles eventually stabilize, and historically, mid and small-cap funds have provided substantial returns when held with the right investment horizon. Balancing risk and reward is the key to navigating these uncertain times effectively.

To conclude...

Investing in mid-cap and small-cap funds amidst volatile equity markets presents both opportunities and risks. In light of the current market volatility, it is crucial for investors to carefully assess their investment goals, time horizon, and risk appetite before committing to mid-cap and small-cap funds.

It is also important to note that the market dynamics are ever-changing. Therefore, a prudent approach would involve maintaining a balanced allocation, ensuring that the investor's portfolio is not overly reliant on the volatility associated with mid and small-cap stocks.

Lastly, investors should keep in mind the importance of regular portfolio reviews, rebalancing the portfolio periodically will help align investments with changing market conditions and personal financial goals.

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MITALI DHOKE is a Research Analyst at PersonalFN. She is an MBA (Finance) and a post-graduate in commerce (M. Com). She focuses primarily on covering articles around mutual funds including NFOs, financial planning and fixed-income products. Mitali holds an overall experience of 4 years in the financial services industry.
She also actively contributes towards content creation for PersonalFN’s social media platforms in the endeavour to educate investors and enhance their financial knowledge.
 

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.