Small caps continue to attract strong inflows. But can investors handle the volatility? What history reveals

Indian investors are continuing to put money into small-cap funds even as the equity market remains volatile. In August, small-cap mutual funds attracted ₹ 7,973 crore, while overall equity mutual fund inflows rose nearly 19% from the previous month to ₹ 29,328 crore. SIP contributions also touched a record ₹ 32,297 crore.

That makes the behaviour of small caps particularly relevant for investors. A FundsIndia analysis of historical market data shows that investors in this segment have had to endure substantially deeper declines than those seen in large-cap indices.

The easiest way to understand the difference is to look at drawdowns. A drawdown measures the fall in an index from an earlier peak. It tells investors how deep the decline became during a period, rather than simply looking at where the index started and ended the year.

FundsIndia's analysis shows that small-cap drawdowns have historically been much more frequent and severe than those in the Sensex.

The difference is striking. A decline of more than 10% from a previous peak occurred on 63% of the observed days for the Nifty Smallcap 100, compared with 33% for the Sensex.

For a decline of more than 20%, the difference widens further. It was seen on 45% of the observed days for the Nifty Smallcap 100, compared with 11% for the Sensex.

And when the decline crossed 30%, the Nifty Smallcap 100 recorded it on 36% of the observed days, compared with just 4% for the Sensex. In other words, a 30% drawdown is not an unusual historical event for small caps in the way it would be for large-cap stocks.

FundsIndia also notes that small caps are more volatile than large and mid caps and have witnessed temporary declines of 15% to 30% almost every year. Only one of the last 22 calendar years had an intra-year decline of less than 10% for the Nifty Smallcap 100.

If an investor looks only at the maximum fall during a year, it can create the impression that the market had a disastrous year. But the maximum drawdown and the final calendar-year return measure two different things.

Consider 2020. The Nifty Smallcap 100 fell as much as 38% from its previous peak during the year. Yet the index ended 2020 with a 16% positive return.

The 2022 example is also important. Small caps fell 16% from their previous peak during the year, but the index still finished the year with a 4% gain.

FundsIndia's broader analysis found that despite intra-year declines of more than 15% occurring almost every year, three out of four years ended with positive returns. It also found that markets ended the year positively 68% of the time, indicating that many of the declines were temporary and subsequently recovered.

This does not mean every fall will recover. It shows why the size of an intra-year correction should not be confused with the final investment outcome.

The data points to a very different risk experience for small-cap investors compared with large-cap investors.