Why blind index investing can hurt in small and midcaps

Simplicity in investing is powerful, but it is not always neutral. In the eagerness to adopt simplified rules and affordability, passive investing is often considered the most suitable option. In practice, excessive capital allocation without rigorous assessment can distort outcomes and elevate risk. That is, when too much money is invested without careful thought, it can lead to unexpected problems.

Indices and their underlying rules do not reset frequently. For example, sometime during 2019-2020, I recall a discussion I had with an index provider regarding a Shariah index. We debated why a particular automobile manufacturer was not included in the index, even though its core business was clearly Shariah-compliant.

The reason lay in the financial screening rules. Due to an industry slowdown, the company’s operating income had declined, while excess cash on the balance sheet was earning interest. As a result, interest income exceeded the permissible threshold as a percentage of total income, leading to its exclusion under Shariah financial-ratio criteria.

However, for an active investment manager, the rationale behind stock selection may differ from that of an index provider. For him, it could mean that the company was at the bottom of its business cycle and entering a recovery phase, where operating revenues would normalise and the income mix would automatically correct. Whereas, index methodologies apply static, point-in-time rules without accounting for cyclical transitions or forward-looking business recovery. This is one of the key differences between active and passive management.

Similarly, in the small and Mid-Cap segment, while companies carry significant growth prospects, they are also characterised by volatile cycles, inconsistent liquidity, and valuations that can swing from optimism to anxiety within weeks. Implementing a strict, rule-based system in this space may sometimes amplify risks rather than mitigate them.

Most small and mid-cap Index Funds follow market-cap-weighted indices. As the price of a stock increases, its weight in the index grows, prompting passive funds to buy more, even when valuations move well beyond fundamental or comfort levels. When market sentiment reverses, these funds remain invested. Rules prevent them from reducing exposure or shifting to cash. This mechanical approach often results in buying what may appear optically expensive and continuing to hold assets that are declining.

This is where active management proves its worth. Active investors can evaluate whether a stock’s rise is justified by business opportunity, future earnings potential, and business stability, or whether it is merely driven by sentiment. Based on this analysis, active funds can reduce exposure when valuations become excessive and increase it when fear outweighs value. This ability to adapt to change, rather than simply follow it, makes active funds different from passive funds.

The Small-Cap segment is not just volatile; it is a reservoir of exponential growth potential that demands nuanced attention. Data show that the number of small companies crossing the Rs 5,000 crore market-cap threshold has grown fourfold since 2017 (from 112 in 2017 to 492 by 2025).

(Source: AMFI & Internal Research. For illustration purpose only. | 2017 data as on December, 2017 and 2025 data as on June, 2025. | Market Cap Data is Average of All Exchanges (Rs Cr) | Categorisation as per SEBI Circular dated October 6, 2017. Past performance may or may not sustain in future and is not a guarantee of any future returns.)

This growth is validated by performance and multipliers. Select companies from the small-cap universe have demonstrated the ability to generate 10x, 15x, and even 25x growth multipliers in more than 3 Years investment horizon, something rarely seen in the Large-Cap space, where the highest multiplier has typically been around 3x-5x. (Source: ACE Equity - Internal Research)

The small-cap space is also a powerhouse for key themes, with broader representation in areas that have limited or no presence in the Nifty 50, such as healthcare, chemicals, and capital goods. These niche business opportunities are among the key reasons for the exponential growth observed in small caps.

Source: NSE, Internal Research, Data as on November 30, 2025

The key takeaway is that passive funds have made investing more accessible, reduced costs, and improved transparency. These achievements have elevated the entire ecosystem. However, when applied indiscriminately to unstable segments such as thematic, small-cap, and mid-cap investing, inflexibility can become a disadvantage.

An effective portfolio should combine passive strategies as its core—broad, cost-efficient, and dependable—while using active judgement to manage complexity. This is especially critical in areas driven by fundamentals, liquidity cycles, and behavioural forces, where human judgement remains indispensable, particularly in the mid, small, micro-cap, and thematic segments.

Disclaimer: The opinions expressed above are of the author and may not reflect the views of DSIJ.