Mid Cap vs Small Cap Mutual Funds - Higher Returns or Higher Risk

Small cap funds delivered 47.5% returns in 2023. Then 29.3% in 2024. Then crashed 7% in 2025, marking the worst year in seven years. (Whalesbook)

Mid caps? They fell too, but only half as much.

This is the reality of the mid cap vs small cap debate that most articles won't tell you. Both categories promise high growth. Both deliver volatility. But the nature of that volatility is dramatically different.

At Belong, we talk to NRIs daily who made the mistake of putting retirement savings into small caps because "past returns were amazing." When markets corrected 40%, they panicked and sold at the bottom. 

The problem wasn't the fund category. It was the mismatch between their risk tolerance and their investment choice.

This guide compares mid cap and small cap funds honestly. Not just the returns, but the risks that come with them. 

The liquidity challenges most articles ignore. The realistic expectations you should set. 

And most importantly, which category actually suits your situation as an NRI investor.

The SEBI Definitions: What You're Actually Buying

Before comparing returns, let's be clear about what constitutes each category.

SEBI (Securities and Exchange Board of India) standardized mutual fund classifications in 2017 based on market capitalization rankings:

Mid Cap Companies: Ranked 101st to 250th by full market capitalization. These are 150 companies that have grown beyond the startup phase but haven't yet become India's giants. Examples include Persistent Systems, Indian Hotels, Voltas, and Federal Bank. (SEBI)

Small Cap Companies: Ranked 251st onwards by market capitalization. This includes everything from promising emerging businesses to companies that may never grow bigger. The universe is vast, spanning over 1,000 listed companies. (SEBI)

Mid Cap Funds: Must invest minimum 65% of assets in mid cap stocks.

Small Cap Funds: Must invest minimum 65% of assets in small cap stocks.

The remaining 35% can go to other market caps or debt instruments, giving fund managers some flexibility.

👉 Tip: AMFI publishes an updated classification list every six months. A company can move from small cap to mid cap (or vice versa) based on market performance, which affects fund portfolios.

Returns Comparison: The Numbers Everyone Wants

Let's address the headline question first.

5-Year Average Returns:

• Mid cap funds: 22-32% CAGR (INDmoney)
• Small cap funds: 28-34% CAGR (INDmoney)

Small caps win on raw returns. But here's what those numbers hide.

2025 Performance (Year-to-Date):

• Mid cap category average: 1.9%
• Small cap category average: -4.4%
• BSE Smallcap Index: -7% (worst since 2018)

(Outlook Money, Whalesbook)

Calendar Year Swings:

• 2023: Small caps +47.5%, Mid caps +40%
• 2024: Small caps +29.3%, Mid caps +25%
• 2025: Small caps -7%, Mid caps -5%

The pattern is clear. Small caps amplify everything. They run faster in bull markets and crash harder in corrections. Mid caps offer a middle path with meaningful but more controlled volatility.

Long-Term Index Performance:

(BMSmoney, BMSmoney)

Interesting finding: Over very long periods (10-15 years), mid caps have actually outperformed small caps on a risk-adjusted basis. The extreme small cap gains get diluted by deeper crashes.

Volatility and Risk: Where the Real Difference Lives

Returns are only half the story. Risk metrics reveal what you're actually signing up for.

Standard Deviation (Volatility Measure):

(Dezerv, Gripinvest)

Higher standard deviation means wider swings from average returns. A small cap fund with 20% standard deviation can swing 40% above or below its average in a single year.

Beta (Market Sensitivity):

Small cap funds typically have betas of 1.2 to 1.5, meaning they move more sharply in both directions compared to broader indices. (TradingView)

If Nifty 50 falls 10%, small caps might fall 12-15%. If Nifty rises 10%, small caps might rise 12-15%. This amplification works both ways.

Maximum Drawdown:

During the March 2020 COVID crash:

• Mid caps fell approximately 35-40%
• Small caps fell approximately 45-55%

During the late 2024-early 2025 correction:

• Mid caps corrected 15-20%
• Small caps corrected 25-35%

Some individual small cap funds dropped over 16% during the 2025 correction alone. (Equitymaster)

👉 Tip: Before investing in small caps, ask yourself: "Can I watch my portfolio drop 40-50% and still hold for 10 years?" If the honest answer is no, mid caps are a better fit.

The Liquidity Problem Nobody Talks About

Here's where small caps have a structural disadvantage that most comparison articles ignore.

What is Liquidity Risk?

Small cap stocks trade less frequently than large or mid caps. When everyone wants to sell at once (during a crash), there aren't enough buyers. This forces fund managers to either sell at distressed prices or hold illiquid positions while investors demand redemptions. (INDmoney)

The AUM Explosion Problem:

Small cap fund AUM surged from ₹904 billion in September 2020 to ₹4.34 trillion in September 2025. That's nearly 5x growth in five years. (Belong)

When too much money chases limited quality stocks, two things happen:

1. Valuations stretch beyond fundamentals
2. Liquidity becomes a crisis during corrections

Fund Houses Closing Doors:

Several prominent small cap funds have stopped accepting fresh investments:

• Nippon India Small Cap Fund: Stopped lumpsum inflows
• Tata Small Cap Fund: Restricted new investments
• DSP Small Cap Fund: Limited inflows at various points

(BusinessToday, Finnovate)

Why would a fund house turn away money? Because they can't deploy it responsibly. Large orders in small cap stocks move prices unfavorably, hurting existing investors.

SEBI Stress Test Results:

In March 2024, SEBI mandated stress tests for small and mid cap funds. The results were revealing:

• Nippon India Small Cap Fund: 13 days to liquidate 25% of portfolio, 27 days for 50%
• DSP Small Cap Fund: Over 20 days for 50% liquidation
• Tata Small Cap Fund: Over 20 days for 50% liquidation

(Certified Financial Guardian)

For comparison, most mid cap funds can liquidate 50% of their portfolio in 5-10 days.

What does this mean practically? During a market crash, if everyone rushes to redeem, you might not get out at the price you expect. Early redeemers get better prices than those who wait.

Mid Caps: Better Liquidity Profile

Mid cap stocks trade more actively. Companies ranked 101-250 have sufficient analyst coverage and institutional interest. Fund managers can enter and exit positions without dramatically moving prices.

This doesn't mean mid caps are risk-free. But the liquidity risk is structurally lower than small caps.

Investment Horizon: How Long Can You Actually Wait?

Both categories require patience. But the minimum timeframes differ significantly.

Mid Cap Funds:

• Minimum recommended: 5-7 years
• Ideal horizon: 7-10 years
• Probability of negative returns drops significantly after 5 years

Small Cap Funds:

• Minimum recommended: 7-10 years
• Ideal horizon: 10-15 years
• Probability of negative returns remains elevated even at 5 years

(Dezerv, GoiNRI)

Rolling Returns Analysis:

Research on Nifty Midcap 150 shows:

• 1-year returns: High volatility (25.48% standard deviation), 6 negative years out of 20
• 5-year CAGR: All 16 rolling periods positive
• 10-year CAGR: Minimal volatility (3.96% standard deviation), all periods positive

(BMSmoney)

For Nifty Smallcap 250:

• 1-year returns: Very high volatility, more negative years than mid caps
• 5-year CAGR: Strong (31.74% current), but with periods of underperformance
• 10-year CAGR: Lower than mid caps (14.10%)

(BMSmoney)

The key insight: Small caps need more time to smooth out volatility. The probability of negative returns is higher over short to medium periods.

👉 Tip: If you're investing for a goal 5-7 years away (like a child's higher education), mid caps are more appropriate. Small caps should only be considered for goals 10+ years away.

Expense Ratios: The Cost of Active Management

Both categories require more research effort than large caps, which reflects in higher expense ratios.

Typical Expense Ratios (Direct Plans):

(Belong)

Why are small cap funds more expensive?

1. Research intensity: Small companies have less analyst coverage. Fund managers must do more independent research, including management meetings and site visits.

2. Trading costs: Lower liquidity means higher impact costs when buying or selling.

3. Portfolio management complexity: Managing a diversified small cap portfolio requires tracking hundreds of smaller companies.

Top Performers by Expense Ratio:

Mid Cap:

• Kotak Emerging Equity: 0.43% (21.5% 5-year return)
• Edelweiss Mid Cap: 0.43% (28.10% 5-year return)

Small Cap:

• Bandhan Small Cap: 0.40% (27.9% 5-year return)
• Invesco India Smallcap: 0.48% (36.16% 5-year return)

(Belong)

The good news: Competition has pushed down expense ratios across both categories. You can find excellent funds in either category with sub-0.5% expenses.

When Mid Caps Make More Sense

Mid cap funds suit you better if:

Your investment horizon is 5-7 years. You need growth but can't afford extreme volatility. Goals like a child's education, a down payment, or early retirement fall here.

You want growth with some stability. Mid caps offer the "sweet spot" between large cap safety and small cap aggression. They're the compromise category.

You're building your secondary equity allocation. Most advisors recommend large caps as the foundation (40-60%), mid caps as the growth driver (20-30%), and small caps as the satellite (10-20%).

You prefer better liquidity. If you might need to exit partially during market stress, mid caps offer faster, cleaner exits.

You're new to equity investing beyond large caps. Mid caps let you experience higher volatility in a manageable dose before deciding if small caps suit your temperament.

Markets are expensive. During stretched valuations, mid caps typically correct less than small caps. Their risk-reward is more balanced when markets are frothy.

When Small Caps Make More Sense

Small cap funds suit you better if:

Your investment horizon is 10+ years. Long timeframes allow small caps to recover from deep crashes and compound gains across multiple market cycles.

You have genuinely high risk tolerance. Not just claiming high risk tolerance, but actually being able to watch 40-50% drawdowns without panic-selling.

You're young and accumulating wealth. A 25-year-old NRI with a 30-year horizon can afford to be aggressive. Time heals most small cap wounds.

You already have large and mid cap exposure. Small caps work as a satellite allocation, adding growth potential to a stable core portfolio.

You invest via SIP. Rupee cost averaging helps smooth out small cap volatility. You buy more units when prices crash, which benefits you when markets recover.

You believe specific sectors will boom. Small caps often dominate emerging sectors like specialty chemicals, renewable energy, or defense manufacturing. If you have sector conviction, small caps offer concentrated exposure.

The Behavioral Challenge: Can You Actually Hold?

Here's the question most investors don't ask themselves honestly: What will you do when small caps crash 40%?

The 2025 Reality Check:

The BSE Smallcap index fell from ~23,000 in December 2024 to ~17,405 by March 2025. That's a 24% crash in three months. (Equitymaster)

Over 660 stocks within the BSE 1000 index reported negative returns in 2025. Some individual stocks fell 60%+. (Whalesbook)

What did investors do? Many stopped SIPs. Some redeemed at the bottom. The SIP stoppage ratio spiked during corrections. (Outlook Money)

This is exactly backwards. Corrections are when SIPs work best. But human psychology doesn't operate on spreadsheets.

Mid Caps: Easier to Hold

Mid cap corrections are painful but more manageable. A 25% drop is psychologically easier to weather than a 45% drop, even if both eventually recover.

If you've never experienced a small cap crash with real money, start with mid caps. Experience the volatility. Understand your actual (not theoretical) risk tolerance. Then decide if small caps belong in your portfolio.

👉 Tip: The best fund category is the one you can actually hold through a full market cycle. A mid cap fund held for 10 years beats a small cap fund sold in panic after 2 years.

Portfolio Allocation: A Framework for NRIs

Most NRI investors shouldn't choose between mid caps and small caps. They should hold both, in appropriate proportions.

Suggested Allocation Within Equity:

This assumes your overall portfolio also includes debt allocation appropriate for your age and goals.

The Core-Satellite Approach:

• Core (60-70%): Large cap index fund or flexi cap fund
• Primary satellite (20-25%): Mid cap fund for growth
• Secondary satellite (10-15%): Small cap fund for aggressive growth

The core provides stability and market returns. Satellites aim to outperform but can underperform in specific periods.

Fund Selection Within Each Category:

Don't hold multiple funds in the same category. Two mid cap funds own similar stocks. You create tracking complexity without adding diversification.

One quality fund per category is sufficient:

• 1 large cap or flexi cap fund
• 1 mid cap fund
• 1 small cap fund (if appropriate for your risk profile)

NRI-Specific Considerations

As NRIs, you face additional factors beyond just returns and risk.

Tax Treatment

Both mid cap and small cap funds have identical tax treatment for NRIs:

• Short-term capital gains (under 12 months): 20%
• Long-term capital gains (over 12 months): 12.5% above ₹1.25 lakh exemption

TDS is deducted at source. You can claim refunds by filing ITR if TDS exceeds actual liability.

Tax treatment doesn't favor one category over another. But frequent switching triggers taxes each time. Long-term holding is tax-efficient regardless of which category you choose.

Currency Impact

The rupee depreciates 3-4% annually against the dollar over long periods. (RBI)

For NRIs earning in dollars or dirhams:

• Your actual returns in home currency = INR returns minus depreciation
• Higher volatility categories (small caps) combined with currency risk can create uncomfortable short-term scenarios

A small cap fund returning 25% in INR while the rupee depreciates 4% gives you roughly 21% in USD terms. But if small caps crash 30% while rupee also weakens, your USD returns are worse than -30%.

Repatriation Planning

If you're planning to return to India within 5-7 years, your effective investment horizon is shorter than you think.

You'll need to reorganize your portfolio before returning. This argues for more mid cap allocation if you're nearing your return date. Small caps should be reduced as your return approaches.

FATCA Restrictions

US and Canada-based NRIs face limitations. Many AMCs don't accept investments due to FATCA compliance requirements. Check fund availability before making allocation decisions.

GIFT City mutual funds offer an alternative with zero capital gains tax for NRIs, though fund selection is more limited. Explore options like DSP Global Equity Fund or Tata India Dynamic Equity Fund.

SIP vs Lump Sum: Which Works Better?

For both categories, SIP generally outperforms lump sum investments, but the advantage is more pronounced for small caps.

Why SIP Works Better for Small Caps:

Extreme volatility means lump sum investments can face immediate 20-30% drops. SIP averages out purchase prices and reduces timing risk.

Example: A ₹25,000 monthly SIP for 5 years in a top small cap fund grew to ₹33.3 lakh on ₹15 lakh invested. (ZeeBusiness data)

The same lump sum invested at a market peak might still be recovering from the initial crash.

For Mid Caps:

SIP remains beneficial, but the advantage over lump sum is smaller. Mid cap volatility is more manageable, so timing matters less.

👉 Tip: For small caps, SIP is almost mandatory. For mid caps, SIP is recommended but lump sum can work if you have a genuine 7+ year horizon and can stomach short-term volatility.

The GIFT City Alternative

Here's something most mid cap vs small cap articles won't mention.

GIFT City mutual funds offer NRIs zero capital gains tax on redemptions. (IFSCA)

Regular Indian mutual funds charge 12.5-20% tax on gains. On a ₹50 lakh gain, that's ₹6.25-10 lakh in taxes saved.

GIFT City funds are denominated in USD, which eliminates currency conversion timing decisions and provides natural hedging.

For NRIs investing significant amounts with long horizons, the tax savings alone justify exploring GIFT City options through Belong's platform.

Use Belong's Mutual Funds Explorer to compare available options.

Common Mistakes to Avoid

Chasing Past Returns

The small cap fund that gave 45% last year might give -15% next year. In 2023-24, small caps were heroes. In 2025, they were laggards. Look at rolling returns across multiple periods, not just trailing returns.

Ignoring Liquidity Risks

Large AUM in small cap funds is a warning sign, not a badge of honor. When funds get too big, they struggle to deploy capital and face redemption pressure during crashes.

Overallocating to Small Caps

Putting 50% of your equity in small caps because "returns are higher" ignores the risk side of the equation. Most advisors recommend 10-20% maximum allocation.

Stopping SIPs During Corrections

The 2025 correction saw massive SIP stoppages. This is exactly backwards. Corrections are when SIPs work best. You're buying more units at lower prices.

Expecting Mid Cap Stability

Mid caps aren't "safe." They're safer than small caps, but they're still high-volatility equity instruments. A 25-30% drawdown is entirely possible.

Ignoring Fund Manager Track Record

In both categories, active management matters more than in large caps. Fund manager skill can differentiate returns by 5-10% annually. Check experience, tenure, and performance across market cycles.

Make Your Decision

The mid cap vs small cap debate isn't about which is "better." It's about which matches your reality.

Choose mid caps if:

• Your horizon is 5-7 years
• You want growth with manageable volatility
• You value liquidity
• You're expanding beyond large caps for the first time

Choose small caps if:

• Your horizon is 10+ years
• You can genuinely tolerate 40-50% drawdowns
• You already have large and mid cap exposure
• You're young and accumulating wealth

Choose both if:

• You have a long horizon and can calibrate allocations
• You want to diversify across market caps
• You understand each category's role in your portfolio

The worst choice? Picking small caps purely because past returns look attractive, then panicking during the next correction.

If you're unsure which allocation suits your situation, join our WhatsApp community where NRIs discuss these decisions daily. Get perspectives from others who've navigated similar choices.

Download the Belong app to explore GIFT City mutual funds with zero capital gains tax, compare NRI FD rates for the stable portion of your portfolio, and use our Residential Status Calculator to ensure your investments are structured correctly.

The market will always offer both opportunity and risk. Your job is to match them to your reality.

Author: Ankur Choudhary & the Belong Team IIT Kanpur alumnus, SEBI-registered investment advisor, and co-founders of Belong, helping NRIs make smarter financial decisions.

Published: December 2025

Sources:

• SEBI - Mutual Fund Categorization
• BMSmoney - Index Performance Analysis
• Equitymaster - Small Cap Correction Analysis
• INDmoney - Fund Category Data
• Whalesbook - Small Cap 2025 Performance
• Outlook Money - Fund Performance Data
• IFSCA - GIFT City Regulations
• BusinessToday - Small Cap Fund Restrictions
• Quantum AMC - Liquidity Analysis