Diagnosing the investors’ pain - 2

As I mentioned yesterday (see here) the pain being felt presently by the non-institutional investors is disproportionately high. For the investors and traders who have spent a short period of time in the market, mostly those who started investing in post Covid period, the pain may be actual, while for those who have been investing for a long time, the pain might only be notional due to perception of relative underperformance or loss of opportunity cost.

Over exposure to small cap stocks

While large caps account for ~60–63% of total and free-float market capitalization, retail participation in this segment has been relatively muted. Institutional investors—both domestic and foreign—continue to dominate ownership and trading activity in large caps. As a result, price discovery here has been more orderly, liquidity deeper, and drawdowns relatively contained.

In contrast, non-institutional investors (retail investors, HNIs, family offices, and smaller proprietary books) have had disproportionately higher exposure to small cap stocks. This skew became more pronounced during the 2020–2023 period, when abundant liquidity, low interest rates, and a sharp post-COVID earnings rebound created an ideal environment for risk-seeking behavior.

Small caps offered three things that large caps could not during that phase:

·         the promise of rapid earnings growth,

·         the possibility of valuation re-rating, and

·         the psychological appeal of “finding the next multibagger”.

This led to a powerful feedback loop—rising prices attracted incremental capital, which further pushed up prices, often well ahead of fundamentals. Valuation discipline gradually took a back seat.

Consequently, though the tradeable (free float) market cap of 5000 small cap stocks is approximately 17% of the total tradeable market cap, over 35% of the total asset under management (AUM) of mutual funds, AIF and PMS etc. is invested in small cap stocks. Smallcap funds witnessed 37% yoy AUM growth in FY25.

Margin Trade Finance (MTF): the hidden amplifier

Another critical, and often underappreciated, contributor to the current pain has been the sharp rise in Margin Trade Finance (MTF) positions, especially in mid and small cap stocks. Over the last few years, MTF became more accessible, cheaper, and widely marketed. Many investors used leverage not for short-term tactical trades, but for holding structurally illiquid small cap names.

This worked exceptionally well on the way up. However, leverage has a habit of revealing itself brutally on the way down.

As small cap stocks started correcting, even modest price declines triggered margin calls. Forced selling followed—not because of deteriorating business fundamentals in every case, but because leverage reduced the ability to absorb volatility. This has exacerbated downside moves and compressed recovery attempts, thereby deepening investor discomfort.

Importantly, this phenomenon does not show up clearly in index-level data. Indices are weighted by market capitalization, while investor pain is weighted by position concentration and leverage. The two are very different.

Normalization, not necessarily a breakdown

The current correction in small cap stocks should also be viewed in a broader historical context. Between 2020 and 2023, small cap indices and several individual stocks delivered returns far in excess of long-term averages—both in absolute terms and relative to earnings growth. A phase of return normalization was therefore inevitable.

What we are witnessing now appears less like a systemic breakdown and more like a recalibration—of valuations, expectations, and risk appetite. Such phases are uncomfortable, but they are also an integral part of healthy market cycles.

For investors, the key takeaway is not to extrapolate past excess returns indefinitely, nor to assume that all pain signals permanent damage. The real task lies in reassessing portfolio construction—especially exposure to illiquid names, leverage usage, and valuation sensitivity—so that future volatility becomes survivable rather than debilitating.

 

What to do now?

Investors need to have a hard relook at their investment strategies and portfolios, and carry out the following five corrections, if needed, in my view:

·         Calibrate all deviations from the predetermined asset allocations.

·         Resize the disproportionate allocations to small and midcap stocks.

·         Exit narrative and momentum stocks where the fundamentals are weak or do not support the stock price.

·         Deleverage.

·         Review your advisors’ quality, and look for alternatives if needed.