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Small caps, while volatile, offer superior wealth creation opportunity

ICICI Direct 7 Mins 08 May 2026

ICICI Securities Ltd - INZ000183631

Small-cap stocks have seen sharp movements over the last few years. After a correction between September 2024 and March 2026, the Nifty Smallcap 250 Index rebounded more than 20% from its March lows. This recovery reflects strong investor interest at lower levels.

The small-cap segment now appears well placed for the next phase of the market cycle. At the same time, the sharp rally seen in recent months also calls for a measured investment approach. Investors may consider investing gradually or buying during market dips.

Why Small Cap ETFs Are Gaining Attention

Small-cap stocks are known for higher volatility. Stock performance within the segment can vary widely, and returns across actively managed small-cap funds have also shown a large gap over different time periods.

The best-performing active small-cap fund delivered returns of 31% over three years, while the weakest fund delivered 14% over the same period. Similar differences were seen across five-year and ten-year periods as well.

Small-cap Exchange Traded Funds help investors gain exposure to a wider basket of companies. This diversification can reduce stock selection risk and allow investors to focus more on asset allocation during different market phases.

Small-cap Exchange Traded Funds have historically outperformed the category average during strong bull market phases. Investor interest in this category is also increasing, with several asset management companies launching new offerings.

The Markets Move in Cycles

Equity markets usually move through cycles. Bull phases are often followed by consolidation or bear phases. Large-cap, mid-cap and small-cap stocks also move through similar cycles.

Small-cap stocks are considered a high beta segment. This means they can rise sharply during strong market phases and fall faster during weak phases. Historically, small-caps have outperformed in rising markets and underperformed during bear markets.

This creates opportunities for investors who are willing to invest during corrections or weak market phases.

Small Cap Recoveries Have Often Been Sharp

The report points out that recoveries in the small-cap segment are often quick. A large part of the gains usually comes within the first one to three months after a correction.

Between 2018 and 2020, small-cap stocks declined nearly 43% and remained subdued for almost two years. This period was followed by a sharp recovery in a relatively short time.

This pattern shows why timing and allocation during market corrections can play an important role in long-term investing.

Long-Term Performance of Small Caps

As of 6 May 2026, the Nifty Smallcap 250 Index delivered a compound annual growth rate of 19% over five years, 16% over ten years, 14.4% over fifteen years and 13% over twenty years.

During the same periods, the Nifty 50 Index delivered 12%, 13%, 12% and 11% respectively.

The report states that small-caps have historically generated strong outperformance during rising markets. At the same time, they also carry higher risk and may underperform during difficult market conditions.

The report advises caution when valuations become expensive or when the segment has already seen sharp outperformance in the recent past.

Data as of May 6th, 2026

Growing Market Size Has Improved Liquidity

The small-cap universe has become much larger over the years. Individual company sizes have also increased significantly, improving liquidity in the segment.

According to the report, the market capitalisation of the top small-cap company increased from ₹1,669 crore to ₹32,808 crore in the last nine years. The market capitalisation of the 500th company also rose from below ₹500 crore to ₹11,758 crore during the same period.

This increase in scale has made small-cap Exchange Traded Funds more investible than before.

Earnings Growth Remains Strong Over the Long Term

The report notes that small-cap earnings growth has been slower than large-caps over the last one year. However, over a longer five-year and ten-year period, growth remains stronger in the small-cap segment.

The Nifty 50 Index is currently trading at around 17 times forward price-to-earnings ratio against earnings growth of around 16%. The Nifty Midcap Index trades at around 22 times forward price-to-earnings ratio against earnings growth of around 17%.

The Nifty Smallcap Index trades at around 17 times price-to-earnings ratio on a two-year forward basis against earnings growth of around 23%, making valuations relatively attractive compared to peers according to the report.

The report also expects earnings growth in the small-cap segment to revive going forward.

 

Small Cap ETFs Are Still a Growing Category

The category is still at an early stage in India. The report mentions that only six small-cap Exchange Traded Funds are currently available, although more launches are expected in the future.

Among the available products, HDFC Mutual Fund’s Nifty Smallcap Exchange Traded Fund has the highest assets under management, exceeding ₹2,000 crore.

Read full report here - https://www.icicidirect.com/mailcontent/idirect_etf_ofthe_month_smallcap_may26.pdf

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