The Hidden Truth About Small-Cap Funds

Most investors are taught a few simple rules: buy good funds, stay invested for the long term, and avoid frequent changes. These rules work very well for large-cap funds and core equity portfolios. Over time, they become our default way of thinking about investing.

In recent years, many investors have started applying the same logic to small-cap funds, encouraged by strong recent returns and the promise of higher growth. What often gets missed is that small-cap funds behave very differently from core equity funds, especially as they grow in size.

After investing in and closely observing small-cap funds over the past ten years, I realised that this difference is important. Small-cap funds follow a different path, and understanding this can help investors make better long-term decisions.

My Observation: A Pattern That Repeats

Small-cap investing benefits from:

Flexibility
Ability to invest in less liquid companies
Meaningful position sizing
Willingness to tolerate short-term volatility

Across many successful small-cap funds, a following pattern tends to appear over time:

Strong early performance
That leads to rising popularity
This increases assets under management (AUM)
And this then results in the gradual moderation of returns

This pattern has been observed across several well-known small-cap funds, including HDFC Small Cap Fund, Nippon India Small Cap Fund, and SBI Small Cap Fund.

This moderation of returns does not happen because:

The fund manager loses skill
The investment process breaks down
Markets stop rewarding small companies

However, the most important reason is the fund size.

Why Size Matters

All of these advantages of small-cap funds depend on a manageable fund size.

As a small-cap fund grows larger:

Liquidity constraints increase
Positions must be smaller
Portfolios become more diversified
Cash levels often rise
Risk management starts taking priority over conviction

These are rational responses to scale, not mistakes. But they do change what the fund can realistically deliver.

The Key Learning: Small-Cap Fund Life Cycle

This led me to an important realisation:

Small-cap funds are not designed to remain high-alpha vehicles forever.

They go through natural life cycles.

Early on, they are flexible, concentrated, and aggressive
Over time, they become larger, more diversified, and risk-controlled

Neither phase is “good” or “bad”. They simply serve different purposes.

Think of a small-cap fund as moving through three broad phases:

Phase 1: Alpha Creation

Low AUM
High flexibility
Concentrated positions
Higher volatility

This is where return potential is highest — and comfort is lowest.

Phase 2: Alpha Harvesting

AUM rising
Still flexible
Best balance between risk and reward
Often the longest holding phase

Most long-term gains are earned here.

Phase 3: Alpha Dilution

Large AUM
Diversification increases
Liquidity dominates decisions
Returns become steadier, but less exceptional

The fund is not broken; it has simply matured.

This is visible in several leading small-cap funds today. The AUM of Nippon India Small Cap Fund has grown to nearly ₹68,000 crore, while HDFC Small Cap Fund and SBI Small Cap Fund now manage over ₹38,000 crore and ₹36,000 crore, respectively. At this scale, a reset in how these funds are positioned within portfolios becomes necessary.

How We Apply This Learning

This perspective leads to a few practical insights:

Past performance alone is not enough
Fund size and structure matter
Staying invested does not always mean staying in the same fund forever
Compounding is protected by process discipline, not by inertia

So, this is what you should do with your small-cap funds:-

Continue SIPs while the fund remains flexible and conviction-driven
When fund size starts constraining strategy, pause SIPs first
Exit gradually when the fund size becomes too large to affect strategy,
Reinvest back into low AUM funds
However, core equity exposure must remain stable

The focus is on protecting long-term compounding, not increasing activity. This understanding does not lead to frequent action. In fact, it leads to less activity, but better decisions.

Conclusion

Small-cap funds require a different mindset from core equity investing. They are powerful tools for generating higher growth, but their effectiveness depends on flexibility, scale, and timing. Treating them as permanent holdings can dilute their purpose, while treating them as short-term trades destroys discipline. The right approach lies in between — staying invested long enough to benefit from opportunity, but aware enough to adapt as that opportunity matures. Used thoughtfully, small-cap funds can meaningfully enhance long-term portfolios without compromising the integrity of compounding.

-- Pady