Understanding Smallcap Index Drawdowns and the Case for Active Investing

This perspective brings out a critical and often under-discussed point — the structural weakness of smallcap indices. The chart analysis highlights that every downtrend in the Nifty Smallcap 100 has overlapped a previous zone, creating a visual and statistical case that downtrends often revisit historical pain points. Whether the current phase does the same and dips into the 12,000 zone is uncertain, but it’s noteworthy that the current drawdown is the shallowest among major corrections over the past 20 years.

Historically, smallcap indices have seen brutal drawdowns:

• 77.4% in 2008
• 66.8% in 2018
• 45%, 31%, 28% in other cycles

Yet, the current fall is comparatively benign. That might be comforting — or it could signal that more pain could be ahead. However, the deeper insight is this: the smallcap index itself is a flawed vehicle for long-term investing.

And here’s why:

Survivorship bias works against the index.
The best-performing smallcaps over time grow in size and move out of the index to join the midcap and largecap universe. The index retains the laggards or weaker stocks, which continue to drag performance.

Smallcap index = Exit point for winners.
While largecap indices retain their winners (like a successful HDFC Bank or Infosys stays in Nifty 50), the smallcap index keeps losing its strongest constituents to higher cap segments.

Active investing shines here.
Unlike the index which is always losing quality names, an actively managed smallcap strategy can keep rotating into new potential winners, staying away from the perpetual underperformers. And this is why despite the index only going from 6,000 to 14,000 in 17 years, numerous smallcaps have delivered multibagger returns within this period — but outside the index.

Passive smallcap or midcap ETFs have an inherent handicap.
Investing in them is essentially investing in a decaying portfolio that’s losing its cream regularly. A good smallcap investor must churn the portfolio proactively, which only active strategies can do well.

In short, the smallcap index is not representative of the opportunity in smallcaps, it is only representative of its structural limitations. A passive approach here underutilizes the full potential of this high-growth space.

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