The Indian equity market witnessed a significant shift in investor sentiment during the calendar year 2025, particularly for the high-flying small-cap segment. After a prolonged period of impressive gains, the small-cap mutual fund category faced a severe reality check, emerging as one of the clear underperformers among diversified equity investment options.
A Year of Sharp Correction for Small-Caps
Excessive valuations built up over previous years corrected meaningfully in 2025, triggering a steep decline. The severity of this market adjustment was reflected in the Nifty Smallcap 100 index, which fell by 7% over the year. This downturn impacted nearly all funds in the category, with most ending the period with negative returns.
In this challenging environment, Quantum Small Cap Fund stood out as the solitary performer, delivering a positive return of 1.81%. It was the only fund in its category to finish the year in positive territory. Following it were funds like Sundaram Small Cap, HDFC Small Cap, PGIM India Small Cap, and ICICI Prudential Smallcap Fund, all of which posted negative returns ranging between -1.56% and -1.88%.
The Stability of Bank Fixed Deposits in Volatile Times
In stark contrast to the volatility experienced by small-cap equities, traditional bank fixed deposits (FDs) continued to provide investors with better stability and predictable returns throughout 2025. Most large banks offered FD interest rates between 6% and 7.5%, ensuring capital protection and assured returns.
While bank FDs effectively shield investors from market swings and serve as a crucial safety anchor within a diversified portfolio, they often struggle to outpace inflation over very long periods. Their return potential is typically lower compared to equity investments. This highlights the classic trade-off between the security of FDs and the higher risk-and-reward profile of small-cap mutual funds.
Long-Term Story Reveals Strong Small-Cap Potential
Despite the disappointing short-term performance in 2025, a look at the five-year horizon paints a radically different and more optimistic picture. Several well-managed small-cap funds continued to deliver exceptionally strong compounded annual growth rates (CAGR), underscoring the critical importance of patience, disciplined investing, and superior stock selection in this volatile segment.
Even with negative or muted returns in 2025, the five-year CAGR of the top-performing small-cap funds ranged between an impressive 25% and 31%. This performance significantly outpaced the Nifty Smallcap 250 TRI, which posted a one-year return of around -6.91% and a five-year CAGR between approximately 22.0% and 26.6% by late 2025.
Top Small-Cap Mutual Funds by Five-Year CAGR
The long-term leaders, based on the performance of their Direct Plans, demonstrate varied investment styles:
Quant Small Cap Fund: Maintaining its category leadership over the long term, the fund achieved a five-year CAGR of over 30%. Its aggressive, high-conviction strategy led to amplified volatility in 2025 but rewarded steadfast investors handsomely over full market cycles.
Nippon India Small Cap Fund: This fund delivered a robust five-year CAGR of around 28%, showcasing strong execution and resilience across different market conditions.
Bandhan Small Cap Fund: Long-term investors in this fund benefited from a solid five-year CAGR exceeding 27%.
Invesco India Smallcap Fund: Achieving a CAGR of over 27% across five years, the fund's performance was aided by disciplined risk management and a competitive expense ratio of about 0.40%.
Edelweiss Small Cap Fund: With a five-year CAGR of approximately 26%, this fund reflects a balanced approach that prioritizes both growth and risk control, making it one of the steadier performers in the category.
Understanding the Risk and Reward of Small-Cap Investing
Small-cap mutual funds invest in companies with a market capitalization typically below ₹5,000 crore, usually those outside the top 250 listed firms in India. These businesses are often in the early stages of their growth cycle and are relatively less known. This obscurity can create opportunities for outsized returns but also exposes investors to high volatility and sharp drawdowns in the short to medium term.
The key advantage of these funds is the early exposure they provide to potential future market leaders, which can translate into higher long-term return potential. However, they are best suited for very aggressive investors with a minimum investment horizon of seven years or more. Such investors must have the financial and emotional capacity to withstand interim corrections like the one witnessed in 2025.
The lesson from 2025 is unequivocal: while small-cap investing can be unforgiving and turbulent in the short term, quality fund selection and time in the market remain the most powerful drivers of long-term wealth creation. Investors must align their choices with their risk tolerance and investment goals, using instruments like bank FDs for stability and small-cap funds for growth, within a well-planned portfolio strategy.
