Small Caps After the Boom: Why 2025 Has Been a Reality Check

You know the feeling: you’ve watched the first half of a film, you’re hooked and you walk into Part Two expecting the same thrill. Then the sequel arrives, overpromises, underdelivers and leaves you wondering what happened to the magic. That, in many ways, has been 2025 for Indian equities.

From 2020 to 2024, the Small-cap 250 enjoyed a dream run. Four of those five years delivered double-digit gains, powered by abundant liquidity, low interest rates and a sharp post-COVID earnings rebound. It was the perfect cocktail for risk-taking. Rising prices attracted incremental capital, which in turn pushed prices even higher—often running well ahead of fundamentals. A self-reinforcing loop took hold and small caps became the market’s favourite story.

But markets have a habit of humbling the most popular narratives. In calendar year 2025, the rug was pulled from under the Small-cap 250, which fell by about 7 per cent and sharply underperformed the frontline benchmarks. The Nifty and Sensex, by contrast, gained roughly 10 per cent and 9 per cent respectively. In simple terms, leadership changed—and small caps paid the price

The reason is not hard to spot. The 2020–2024 rally was largely liquidity-led. 2025 has demanded something different: earnings delivery and fundamental credibility. When expectations sit on a high pedestal, disappointment tends to be ruthless. Valuations had stretched to extremes; small caps were trading at around 36 times earnings at their peak, well above the long-term median. When earnings growth fell short of what the market had priced in, the response was swift: de-rating, not patience.

Liquidity also stepped back. FIIs were net sellers in eight of the 12 months of 2025. Retail investors eased off secondary market buying as well, with a noticeable portion of attention and capital redirected towards IPOs.

Another important signal of tightening global liquidity came from Japan. The Bank of Japan’s decision to raise interest rates to 0.75 per cent, the highest level since 1995, matters far beyond Tokyo. For decades, Japan served as a cheap funding source through the well-known ‘yen carry’ trade. As Japanese yields rise, carry trades unwind, capital becomes more expensive and volatility increases in risk assets—particularly across emerging markets.

So, what would it take for the Smallcap index to climb meaningfully from here? One of two things. Either global liquidity needs to return decisively through FIIs, or domestic institutions must find even more capital to deploy into equities. The second path appears more challenging. In fact, investors should arguably be relieved if retail participation simply holds steady, rather than fading altogether after a year of muted returns.

FII flows, meanwhile, remain uncertain. India has gone from being a global outperformer between 2020 and 2024 to looking like a laggard in 2025. As of the end of November 2025, the MSCI India Index was up about 8.1 per cent, less than half the MSCI World Index’s 18.6 per cent gain. Over the same period, major markets such as the S&P 500, Hang Seng, Nikkei and FTSE 100 delivered strong performance. Add rupee weakness to the mix and India’s relative appeal becomes harder to sell to global allocators.

Still, it is not all gloom. There are glimmers of hope. India’s GDP growth has surprised on the upside, positioning it among the world’s fastest-growing major economies despite Trump’s tariff theatrics. Corporate earnings have also shown early signs of recovery in Q2 FY26.

For now, India’s strongest support lies in continuing to deliver on GDP growth and earnings, allowing valuations to become attractive once again. Any easing of Trump-era tariff tensions would provide a timely boost to sentiment.

Disclaimer: The article is for informational purposes only and not investment advice.