Mid- and small-cap funds continue to draw investors despite volatility and valuation concerns. What is driving the interest?

Investors don’t seem ready to give up on the smaller end of the market just yet.

In July, small-cap mutual funds received Rs 7,767.50 crore, the highest among equity fund categories, while mid-cap funds attracted another Rs 6,192.31 crore. Large-cap funds, meanwhile, saw Rs 1,321.69 crore move out.

Returns offer one explanation for the interest. Small-cap funds are comfortably ahead of mid-cap funds over the shorter term. But stretch the period to three years and there is barely anything separating the two.

Small-cap funds have returned 12.74 percent over the past year compared with 9.68 percent for mid-cap funds. Over three years, however, mid caps are marginally ahead at 15.69 percent versus 15.44 percent.

That brings up a bigger question: with valuations still a concern, what is keeping investors interested in mid- and small-cap funds?

Also Read: What top small-cap funds bought and sold in July as inflows soared

Why are investors still interested?

Earnings are a big part of the answer.

The latest earnings season adds some weight to that argument. According to Motilal Oswal Financial Services’ Nifty 500 review, Nifty Smallcap 250 companies led Q1FY27 earnings growth at 35 percent year-on-year. Nifty Midcap 150 companies, excluding oil marketing companies (OMCs), followed with 30 percent growth, while large caps, excluding OMCs, reported 20 percent growth.

Ankit Jain, Senior Fund Manager at Mirae Asset Mutual Fund, points out that the Nifty Midcap 150 has delivered earnings growth of around 17 percent CAGR over the past nine years, broadly matching the index’s 16.3 percent CAGR return over 10 years.

Investor allocation has also grown. Jain says mid-cap funds’ share of net flows has increased from 14 percent in FY23 to almost 20 percent YTD. He attributes the structural interest partly to mid-sized businesses gaining scale and resilience, while new listings continue to expand the investible universe.

Gaurav Chopra, Fund Manager – Equity at Union Asset Management Company, points to a similar trend. He says the mid-cap segment has sustained mid-teens EPS growth over the past five-six quarters even when broader-market earnings were relatively muted.

The small-cap story isn’t entirely different. Fund managers Moneycontrol spoke to earlier had pointed to improving earnings, a widening investible universe and opportunities arising from manufacturing, capital expenditure and formalisation as reasons why interest in small caps has persisted.

Also Read: Mid-cap inflows crossed Rs 6,000 crore in July: What the top 3 mid-cap mutual funds bought and sold

But what about valuations?

Strong earnings solve only one part of the puzzle. The other is the price investors are paying for that growth.

Jain says the Nifty Midcap 150 currently trades at around 26 times one-year forward earnings, slightly above its historical average of 24.8 times. In the context of mid-teen earnings growth, he considers that valuation reasonable.

Nifty Midcap 150 vs Nifty 50: How valuations have moved over the past decade

Source: Mirae Asset Mutual Fund

Ketan Gujrati, Fund Manager, Equity at Quantum AMC, sounds a more cautious note. He says strong earnings initially supported mid-cap outperformance, but heavy flows into dedicated funds may subsequently have contributed to elevated valuations.

There’s another issue: liquidity. Mid-cap and large-and-mid-cap funds have a relatively limited universe for their mandated mid-cap allocation, and these companies do not offer the same liquidity as large caps. Large inflows can therefore put further pressure on valuations, Gujrati says.

Small-cap valuations aren’t exactly comfortable either. DSP Mutual Fund’s NETRA report recently put the median P/E of small- and mid-cap stocks at around 38 times, down from a peak of 46 times but still well above their long-term average of around 20 times.

Also Read: Small-cap funds attract Rs 7,768 crore in July, corner nearly one-third of equity inflows

The opportunity is becoming more selective

So, a strong outlook for mid caps doesn’t necessarily mean every mid-cap stock looks attractive.

Chopra says stock selection remains critical and sees favourable risk-reward in areas including private banks, NBFCs, select auto ancillaries, capital goods, chemicals and CDMO/CRAMS.

Jain sees opportunities across financials, insurance, pharmaceuticals and healthcare, export-oriented businesses and select consumer-facing businesses. Interestingly, he finds capital goods expensive and remains underweight on the sector.

Gujrati, meanwhile, sees value in NBFCs, insurance, domestic pharma, real estate and rail freight.

For investors, that’s perhaps the more useful way to read the current numbers. Strong inflows show where money is going and past returns show what these categories have delivered, but neither by itself tells you how much you should invest.

Mid- and small-cap funds can offer higher growth potential, but they also come with greater volatility and valuation risk. Your investment horizon, existing allocation and ability to sit through sharp corrections should ultimately determine how much room they get in your portfolio.

Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.