Are Small-Cap Mutual Funds In Bubble Territory Again?

Between January and March 2025, small-cap mutual funds saw net inflows of Rs 13,535 crore. June alone brought in Rs 4,024 crore more. That pushed total AUM in small-cap funds from Rs 2.95 lakh crore in March to Rs 3.54 lakh crore by end-June, a sharp jump of nearly Rs 60,000 crore in just a quarter.

Investor interest in small-caps is strong. But rising inflows don't always mean rising fundamentals. Valuations in the small-cap space are starting to look stretched, while earnings growth hasn't quite caught up with the pace of stock price appreciation.

"It's easy to look at elevated small-cap valuations and worry about a bubble - but this isn't 2008 or 2021. Today's valuations are rooted in India's growth narrative, and the market is anticipating earnings acceleration, sectoral rotation, and a supportive macro backdrop. If those play out, small-cap pricing may be high, but not irrational. That said, investors must tread carefully," said Mr. Anand K Rathi - Co Founder of MIRA Money.

Bubble or Opportunity? Decoding India's Small-Cap Market in 2025

As per Karthick Jonagadla, smallcase Manager and Founder of Quantace Research, India's small-cap shares look expensive, but they may not be in full bubble mode yet.

- Price tag: The Nifty Small-cap 250 index trades at about 34 times its past-year earnings. That is near its highest point in the last twelve months and well above its five-year average, but still far below the wild ≈59× peak seen in 2017-18.

- Fresh money keeps coming: Investors put a record ₹27,269 crore into mutual funds through monthly SIPs in June 2025, and small-cap schemes are major beneficiaries of these steady inflows.

- Returns have cooled: So far in 2025, the average small-cap fund is down roughly 12 %, with the weakest funds off as much as 18 %. The recent pull-back has taken some heat out of the market

"Prices are high and cash is still pouring in, two signs that call for caution. At the same time, the drop in returns shows that euphoria has already been dented. If FY26 company earnings grow strongly over the next couple of years, today's premiums can be justified; if not, valuations may fall further," Karthick Jonagadla added.

For new investments, spreading money over several months rather than making one big bet can help manage risk. Current holders should check how easily their fund can sell its stocks if markets turn choppy-funds holding very thinly traded shares could struggle in a rush for the exit, Karthick Jonagadla stated.

Karthick Jonagadla further recommended that, in short, small-caps are pricey and volatile, but not yet a classic bubble. Stay invested with a clear 3-to-5-year horizon and keep an eye on liquidity and earnings momentum.

Market Rally and Liquidity Risks: How to Play Small- and Mid-Caps Safely in 2025?

Small- and mid-cap mutual funds are currently trading at higher valuations compared to large-caps. However, this premium is somewhat justified by stronger earnings growth expectations.

As of July 2025, the Nifty 50 is trading at a price-to-earnings (PE) ratio of around 22.7x, while the Nifty Midcap 100 and Nifty Smallcap 250 are trading at significantly higher valuations of approximately 33-34x, well above their historical averages.

Despite elevated valuations, earnings projections for FY25-27 provide some support.

"Nifty is expected to grow EPS at 13%, while mid-caps and small-caps are forecasted to grow at 17% and 20%, respectively. On a price-to-earnings-growth (PEG) basis, small-caps look relatively more attractive, trading near 1x, while large-caps are above 1.2x," commented Aakanksha Shukla, AVP, Wealth Management, Master Capital Services.

This indicates that while valuations may seem stretched in absolute terms, they appear more reasonable when adjusted for growth potential. Nonetheless, the recent sharp rally and ongoing concerns around market liquidity warrant caution, Aakanksha Shukla further added.

Aakanksha Shukla further recommended that investors are advised to avoid making large lump-sum investments in small-cap funds at current levels. Instead, systematic investment plans (SIPs) or systematic transfer plans (STPs) are preferred to manage entry risk.

India's Growth Story and RBI Support Keep Small-Cap Momentum Intact

While the small cap stocks are trading at higher valuations as compared to long term averages, it would be imprudent to call mutual funds with high small cap exposure to be in bubble territory.

Gaurav Goel (Entrepreneur and SEBI-Registered Investment advisor) says, "It is expected that in the current financial year as well as in the current quarter, small and mid-cap stocks will outperform the large-cap stocks. Fund flows into small cap schemes remain healthy and investors are not really panicking. The growth remains strong in several sectors and India continued to do well."

All this augurs well for stock markets from a long term perspective and small cap stocks can probably lead the rally despite slightly expensive valuations. Small corrections here and there can't be ruled out, but bubbles in small-cap stocks do not appear to be big enough to burst at the current moment.

Small-Caps Are Pricey, But Far From a Full-Blown Bubble

Trivesh D, COO Tradejini says, We're not calling this a bubble yet, but the signs of froth are hard to ignore. Right now, a lot of retail money seems to be chasing performance. There's momentum, but also a sense of herd behaviour, rapid inflows, soaring AUM, and minimal redemptions. If volatility returns to the market, it will test how sticky this capital is.

"We are in a phase where optimism is high, but being cautious is a reminder. What we are watching closely now is not just how much money is flowing in, but how quickly it could flow out when the tide shifts," said Trivesh D.

A diversified portfolio with a long-term investment horizon of at least five years remains the most prudent strategy to navigate near-term volatility while capturing long-term growth opportunities.

Disclaimer

The recommendations made above are by market analysts and are not advised by either the author, nor Greynium Information Technologies. The author, nor the brokerage firm nor Greynium would be liable for any losses caused as a result of decisions based on this write-up. Goodreturns.in advises users to consult with certified experts before making any investment decision.