Why active funds are more suitable for small- and mid-cap investing
But with great potential comes considerable volatility, and this is where the debate between active and passive investing becomes wealth-defining.
Unlike large-cap companies, which typically offer stability and established cash flows, small- and mid-cap companies often operate in emerging sectors, experience sharper business cycles, and face greater regulatory and competitive risks. These characteristics make them more vulnerable to sentiment shifts and company-specific events, which can cause stock prices to swing dramatically.
Momentum bias
Low-cost passive investment vehicles, including index funds, deliver systematic exposure to these segments through rules-based methodologies. But their structural rigidity becomes a liability when dealing with the unique risks posed by small- and mid-cap stocks.
For instance, when a stock rallies significantly and inflates its market cap, it occupies a larger share in the index. Passive funds, which track the index by design, are forced to increase exposure to this very stock, essentially buying more of what’s expensive and less of what offers value. This creates an inherent momentum bias and systematically exposes investors to overvalued stocks.
This issue is magnified during market downturns. When small- and mid-cap indices fall, passive funds remain tethered to declining assets. They cannot reduce exposure, sit on cash, or pivot to more resilient sectors. Investors in such funds are left fully exposed, unable to escape the slide. Drawdowns in these segments can often exceed 40-50%, erasing years of gains in weeks.
Let’s look at data from June 2015 to June 2025 and from June 2020 to June 2025 to understand the volatility. The Nifty Midcap 150 TRI experienced drawdowns of 43.06% from June 2015 to June 2025 and 21.12% June 2020 to June 2025, with recovery periods of 175 and 59 days, respectively. The Nifty Smallcap 250 TRI registered falls of 59.18% from June 2015 to June 2025 and 26.61% June 2020 to June 2025, requiring 289 and 258 days, respectively, for full recovery.
Active management
Active fund managers, on the other hand, possess the flexibility to make swift, discretionary decisions based on market developments. They can assess when valuations have moved beyond fundamentals, reduce exposure to overheated stocks, and increase holdings in undervalued but fundamentally strong companies during market corrections.
This ability to be selective, to “buy low and sell high,” is core to successful investing, and only active management can consistently deliver it in this space. Many active funds hold cash to manage market volatility and take advantage of opportunities. For example, in April 2025, equity mutual funds held a record ₹2.15 trillion in cash.
Moreover, governance and financial transparency in small- and mid-cap companies vary significantly. Many of these companies are promoter-driven, lack institutional scrutiny, and may not meet the rigorous disclosure standards followed by their large-cap counterparts. Passive strategies offer no recourse here. If a company is part of the index, the fund must hold it, regardless of concerns about governance, accounting practices, or management credibility.
Active managers, by contrast, conduct thorough research and analysis. They meet company management, assess financial reporting quality, and evaluate long-term viability before investing. This process allows them to avoid landmines, companies that may be in indices but are unfit for long-term portfolios.
Another key area where active management shines is liquidity. Small- and mid-cap stocks often suffer from limited trading volumes. During market stress, these stocks can become difficult to transact, with bid-ask spreads widening significantly. Passive funds, which must rebalance portfolios regardless of market conditions, may find themselves moving large positions in illiquid names, amplifying market impact and hurting returns. Active managers can build positions gradually, exit strategically, and even hold cash temporarily to manage liquidity risk.
The best for the segment
The cyclical nature of small- and mid-cap stocks also lends itself to active management. Bull phases commonly create excessive valuations that defy logic, just as bear phases tend to undervalue strong companies relative to their inherent worth. Passive funds ride these cycles indiscriminately.
Risk management in this space demands a nuanced understanding of sectors, value traps, and macroeconomic sensitivities. Active managers can customize portfolios using position sizing, sector allocation, and volatility screens.
Ultimately, while passive strategies may look attractive during broad-based rallies, it’s during market dislocations that the value of active management becomes obvious. For investors seeking sustainable, risk-adjusted returns from the small- and mid-cap universe, active strategies offer the adaptability, insight, and discipline that this segment demands.
Views are personal.
Rahul Bhutoria is a director and co-founder at Valtrust.
