Mutual funds in 2025: Should you look at investment in small-cap funds?

Mutual Funds investment: This year has been quite positive for the domestic markets. It began with an election rally followed by a favourable outcome that was positive for policy construction and future growth. Macroeconomic factors such as stable growth and moderate inflation also helped the markets.

Additionally, globally, the outcomes of the US elections were favorable for Indian politics. From a valuation perspective, India remained relatively expensive compared to other emerging market economies, which resulted in moderated FII inflows in the Indian markets. The market was largely driven by domestic flows, with increased retail contributions and DIIs.

Some sectors that outperformed the benchmark were capital goods, defense, and railways, while sectors such as BFSI and IT underperformed the index.

So far, the Sensex has gained 8.92% and the Nifty has risen 9.49% in 2024. In 2024, the Sensex hit a record high of 85,978 and the Nifty touched a record of 26,277 on September 27.

Moving on to the average returns of small-cap funds between December 2023 and December 2024, they stood at 25.69%. In comparison, mid-cap and large-cap funds gave returns of 26.91% and 14.97% respectively during the same period.

Looking ahead, major triggers could come from the US inflation and how it will unfold. Additionally, supply chain disruptions due to geopolitical conflicts and a potential domestic consumption revival could also impact the market.

Given these factors, is it worth considering small cap funds, which have shown impressive returns in the past year?

Ajay Khandelwal, Fund Manager at Motilal Oswal Mutual Fund, stated that small cap earnings are expected to grow faster than large caps due to their lower leverage compared to historical levels. This has also led to lower stock price volatility and better performance compared to the large cap index.

He said: “We expect manufacturing, power renewable, luxury discretionary products to do well in 2025. Valuations are trading at a premium but have come down with recent correction.”

Mihir Vohra, CIO of Trust MF, said that broader markets are more attractive at this time. He advices to pick up stocks from the small-cap universe which has a long runway for growth. 

He added: “In small caps, we are bullish on premium consumption like high-end real estate, liquor, airlines, hotels, jewellery, healthcare, infra, construction, renewable energy, power and defence.”

When it comes to asset allocation, Vohra suggested diversifying the portfolio with fixed income and gold in addition to equity, especially in light of expected rate cuts and market volatility.

Looking ahead, earnings growth for small and mid-cap companies is expected to be moderate due to already high bases. Overall valuations are high and if growth does not pick up significantly, there may be some market consolidation, particularly in small caps. Abhilasha Satale, Fund Manager at Equity Quantum MF, predicts returns of 10-12% in small-cap funds.

Satale recommends considering sectors like healthcare, insurance, and BFSI with reasonable valuations. Capital goods and PSU sectors may see moderate growth, while there are positive signs of growth in rural and urban consumption.

Varun Goel, Senior Fund Manager of Equity at Mirae Asset Investment Managers, stated, "We believe that for individuals with a 4, 5, or 10-year investment horizon looking to create wealth, investing in small caps makes a lot of sense." 

Despite acknowledging pockets of inflated valuations in the small-cap sector, Goel still advocated to include small caps to an investor's portfolio for the long term, given India's growth potential.