Why Finology Excluded Mid-Cap and Small-Cap Funds for 2025

Investing is all about balancing opportunity and risk, but sometimes the scales tip too far on one side. This year, we decided not to include any mid-cap or small-cap funds in our recommendations. Here’s why:

Small Universe

Mid-cap funds have a rigid mandate — at least 65% of their portfolio must consist of mid-cap stocks. What does that mean? Fund managers must pick from a universe of just 150 mid-cap companies.

Most mid-cap funds hold about 50–75 stocks, so the scope for identifying unique winners gets narrower. While some flexibility exists to invest beyond mid-cap stocks, the fund manager’s room to maneuver is limited. This creates a challenge: finding consistent alpha (returns above the benchmark) in a relatively small pool of options.

In contrast, small-cap funds enjoy a broader universe of stocks. So, while their flexibility isn’t in question, their performance has its own hurdles — which we’ll get to.

Stability becomes more important than anything when you are investing for your goals. Even while picking stocks for Finology 30, we choose stocks that you can rely on for the long-term.

Underperformance: Numbers Speak Louder Than Words

Here’s the harsh truth — the majority of mid-cap and small-cap funds have struggled to beat their benchmarks.

• Mid-Cap Funds: Out of 25 mid-cap funds with a three-year track record, 84% (21 funds) underperformed their benchmarks.

• Small-Cap Funds: 68% of small-cap funds also lagged behind their benchmarks during the same period.

This underperformance is particularly glaring considering the strong returns delivered by the indices themselves. If the benchmarks are thriving and funds are still falling short, it signals inefficiency in capturing the potential of these segments.

SEBI’s Red Flag: Froth in the Markets

In March 2024, SEBI raised concerns about excessive inflows into small-cap and mid-cap stocks.

To put this into perspective:

• In FY25 (so far), mid-cap funds attracted ₹14,756 crore, and small-cap funds brought in ₹15,586 crore.

• Compare this to FY22, where the annual net inflows for mid and small-cap funds were ₹16,308 crore and ₹10,144 crore, respectively.

This surge in inflows has pushed stock prices higher, creating frothy valuations. When markets are fueled by liquidity rather than fundamentals, it adds a layer of risk for investors.

Stretched Valuations: Walking on Thin Ice

Valuations in the small and mid-cap segments are at precariously high levels:

• Nifty Midcap 150 Index: Trading at a PE ratio of 40.73x, well above its five-year average of 28.32x.

• Nifty Smallcap 250 Index: Trading at a PE ratio of 30.85x, compared to its five-year average of 24.14x.

To make matters worse, the median valuations of small and mid-cap stocks are currently double their 2007 levels. High valuations increase downside risks, especially if market conditions shift or economic growth slows.

The Bottom Line:

At Finology, we prioritize investor safety and long-term value over short-term gains. Given the current scenario:

• A shrinking opportunity for mid-cap fund managers to generate alpha.

• A significant portion of funds underperforming their benchmarks.

• Regulatory concerns around market froth.

• Stretched valuations increase downside risks.

We have revealed why we eliminated small and mid-cap funds for 2025 in Recipe’s Free Reports section. Stay tuned!