Market-Cap Reality vs. Fund Flow Distortion

Market Imbalance Overview

India's equity markets continue to display a striking imbalance between the true market-cap structure and the way investors—particularly retail investors—have been allocating their money through mutual funds. This divergence has widened significantly in the post-COVID era, driven by the strong performance of mid- and small-cap segments during 2020–2023 and the perception that these categories offer superior long-term returns.

Ideally, mutual fund flows would broadly reflect this distribution. Instead, the fund flow data reveals the opposite trend. When examining the assets under management (AUM) of the top funds in each category, the imbalance becomes even more pronounced.

Fund Flow Distortion

The assets under management (AUM) tell a different story from the actual market capitalization distribution:

In other words, although mid- and small-cap companies represent only around 42% of the large-cap universe in actual market size, they attract nearly 1.6 times the AUM invested in large caps. This reflects a powerful behavioral trend: retail investors have aggressively chased the outperformance of mid and small caps, often without fully considering the risks associated with stretched valuations, lower liquidity, and heightened cyclicality.

The surge in inflows has pushed these segments to levels where valuations have run ahead of fundamentals. As a result, the vulnerability to corrections has increased significantly. The inherent volatility of mid- and small-caps—usually masked during bull phases—has started resurfacing, making the investment environment riskier than headline index movements may suggest.

Valuations Running Ahead of Reality

The rapid buildup of flows into mid- and small-cap categories has driven valuations to historically elevated levels. Currently, these segments trade at valuations that are difficult to justify based on past or current earnings performance.

Despite many mid and small cap companies having strengthened their balance sheets post COVID largely through deleveraging and improved cash reserves—these balance sheet improvements alone cannot justify valuations that have surged beyond 35 times earnings. The current pricing of these segments reflects optimistic expectations about future growth, expectations that are not yet supported by underlying earnings momentum or actual profit delivery. As inflows continue to outpace fundamentals, the valuation gap between expectation and reality becomes increasingly difficult to sustain.

Cyclicality and Drawdown Risk

Beyond valuations, investors should recognize the inherent cyclicality and volatility that define the mid- and small-cap universe. Over the past two decades, these segments have repeatedly seen drawdowns of 25% or more, often following sharp rallies similar to the one observed in the post-COVID period.

Small caps can deliver extraordinary returns during bullish phases, but this outperformance often masks the severe volatility they experience in downturns. A classic example is the period around the 2008 global financial crisis:

• A notional investment of ₹100 in a small-cap index grew dramatically to ₹754 by December 2007, reflecting the explosive upside potential in strong market environments.
• However, when the cycle turned, the same index collapsed to just ₹174 by 2009, wiping out the majority of the gains and highlighting how quickly momentum-driven returns can reverse.

This illustrates that while small caps can multiply wealth rapidly, they also expose investors to disproportionately large drawdowns. Historical cycles underscore that higher returns in these categories come with significantly greater volatility, and downturns can be both severe and prolonged.

A Time for Prudence and Balance

Despite these challenges, India's long-term structural growth story remains intact, and prudent investing continues to offer attractive opportunities. However, in the current environment of stretched valuations and moderate earnings growth, investors should maintain realistic expectations and emphasize resilience over aggressiveness.