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MUMBAI: With the benchmark Nifty 50 trading just 2% below its 52-week high, India’s equity market appears buoyant. But beneath the surface, a very different story is playing out. The Nifty Smallcap 250 remains nearly 12% off its peak, reflecting a sharp divergence that suggests investors are growing cautious about riskier corners of the market.

Market breadth underscores the unease. Only 10 stocks in the Nifty Smallcap 250 are within 0.5% to 9.9% of their 52-week highs. In contrast, 131 stocks are down between 10% and 30%, while another 90 have fallen even further—by 31% to as much as 69%, according to Bloomberg data.

The imbalance raises a key question: as largecaps power ahead, has investor risk appetite structurally shifted away from smallcaps?

The prevailing view among market participants is that it has not. Instead, they argue the underperformance reflects cyclical caution driven by liquidity pressures, foreign selling, and global macro uncertainty—rather than a permanent change in investor preference.

“Though FII ownership in smallcaps at around 9% is lower than in largecaps at around 20% and average ownership across market caps of around 15.5%, the sell-down by FIIs hurt smallcaps more due to lower liquidity (volume) vs largecaps," pointed out Vinay Jaising, chief investment officer and head of Equity Advisory at ASK Private Wealth.

On a net basis, foreign institutional investors have sold about $2 billion worth of equities in December alone and nearly $18 billion in calendar year 2025 so far, Jaising said, contributing to the relative underperformance of smallcap stocks.

Smallcaps, he added, are inherently more sensitive to global macro shocks—whether a 6-7% rise in the dollar against the rupee or the threat of punitive US trade tariffs on India. At the same time, easing interest rates and a revival in capex and consumption should, in theory, improve earnings visibility and growth prospects for smaller companies more than for the broader market.

While retail investors have turned wary in the near term following sharp price corrections, Jaising believes this is an opportunity rather than a structural break.

From a multi-year perspective, he noted, even after a roughly 9% absolute decline in 2025 and more than 15% underperformance versus largecaps, the BSE Smallcap 250 index remains the second-best performing equity cohort over the past five years, delivering a 24% compound annual growth rate to investors.

Valuations help explain the divergence. According to Bloomberg data, the Nifty 50 is trading at 23.9 times earnings, broadly in line with its five-year average of 24.05 times. The Nifty Midcap 100, at 34.9 times, is slightly below its five-year average. In contrast, the Nifty Smallcap 250 is valued at 30.8 times earnings—well above its five-year average of 27.9 times.

Others, however, see a more nuanced picture emerging.

According to Vipul Bhowar, senior director and head of equities at Waterfield Advisors, smallcaps currently offer mixed alpha-generating potential compared with midcaps and largecaps. While they have historically outperformed during bull phases, they are now under pressure due to elevated valuations and weaker recent performance.

Over the long term, smallcaps can deliver returns of 15-25% or more, Bhowar said, but they also carry the highest volatility and liquidity risk during market corrections. Midcaps, by contrast, strike a balance with moderate growth of 12-17% and relatively greater stability, while largecaps prioritise lower-risk reliability with returns in the 10-14% range.

Bhowar believes that stronger quarterly earnings, a renewed focus on quality companies with reasonable PEG ratios, and an improvement in global risk appetite could draw long-term investors back to smallcaps. A slowdown in IPO supply and the easing of curbs on small-cap fund inflows could further support sentiment.

Net inflows into small-cap funds peaked in July at ₹6,484.43 crore, the highest level this year, before moderating in subsequent months, according to data from the Association of Mutual Funds of India (Amfi) data. In November, inflows stood at ₹4,406.90 crore, higher than October but still well below the July peak.

Even so, investment bankers point to a discernible behavioural shift among certain investors, particularly family offices, who are increasingly gravitating towards larger, more established names.

For the past couple of months, the market has been in a consolidation phase, with institutional capital visibly chasing size and value, said Vipin Singhal, director at Anand Rathi Investment Banking. “Investor appetite for small-cap IPOs has become noticeably more selective rather than risk-averse in absolute terms, which seems to be influenced by both higher valuations and a moderation in secondary market sentiment."

He sees this sentiment as a reflection of slowing earnings momentum, especially among export-oriented businesses, along with profit-taking and tighter liquidity conditions amid global interest rate and geopolitical uncertainties. Unlike the previous cycle, he added, smallcap valuations are now easing rather than being pushed aggressively higher at the IPO stage.

Singhal also views the current phase as cyclical rather than structural, though with a sharper focus on quality. Family offices, he said, are increasingly leaning toward early-stage venture capital and private equity-style investments as a way to diversify, seek higher long-term returns, and deploy patient capital amid the underperformance of listed IPOs.

“In the current phase of the market, family offices are prioritising downside protection, balance sheet strength, and earnings visibility," he said.

The broader expectation remains that family offices and long-term investors will increase allocations to smallcaps once valuations reset further, market breadth improves, and earnings begin to meet expectations.

Echoing that view, Sunny Agrawal, head of fundamental research at SBI Securities, said investor interest will return to select mid- and small-cap stocks capable of delivering sustainable, profitable growth at reasonable valuations. For now, he said, the market has firmly entered a bottom-up, stock-picker’s phase.

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