Why Active Funds May Work Better for Small-, Mid-Caps

Research helps active managers to rebalance holdings, hold cash and avoid weak stocks

- Rahul Bhutoria

The Indian equity market's small- and mid-cap segments have long captured the attention of growth-oriented investors. These companies promise exponential returns that can transform portfolios, especially for investors willing to ride the wave of market cycles. 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 vehicles such as index funds offer systematic exposure to these segments through rules-based methods. But their rigidity can be a drawback with small- and mid-cap stocks. When a stock rallies and inflates its market cap, it takes a bigger weight in the index. Passive funds tracking it must raise exposure, buying more of what's expensive and less of what offers value. This builds a momentum bias and exposes investors to overpriced stocks.