Small-cap mutual funds have emerged as the best-performing equity category over the past six months, delivering an average return of nearly 21.26%, outperforming other domestic equity categories and international funds, an analysis by ETMutualFunds showed. The category has also maintained its momentum over the last one month, raising questions about what is driving the sharp recovery and whether the rally can sustain.Rajesh Minocha, a Certified Financial Planner (CFP), Founder of Financial Radiance told ETMutualFunds that the recent rise in small caps appears to be a rebound from earlier declines, supported by improved investor sentiment, increased domestic liquidity, selective stock picking by fund managers and expectations of stronger earnings.However, he cautioned investors against interpreting one or two months of strong gains as confirmation of a sustained uptrend. Small-cap stocks tend to be more volatile and sensitive to market flows, and therefore recent returns should not be extrapolated into the future.Also Read | Explained: Looking to start a mutual fund SIP? Know the different types and which one suits youNilesh D Naik, Head of Mutual Funds, PhonePe shared with ETMutualFunds that the primary driver of this performance has been strong earnings growth in small-cap companies for Q1 FY27.Year-on-year earnings growth in small-cap stocks, excluding Oil and Gas, exceeded 30% for the quarter and this rally also followed a sharp correction in small-cap stocks in March 2026 so given current valuations, future trends will be largely influenced by earnings growth, Naik further said.Small cap funds performance in 6 monthsThere were 34 funds in the category in the said time period, of which Bank of India Small Cap Fund delivered the highest return of around 35.02% followed by TrustMF Small Cap Fund who gave 31.27% return in the last six months.HDFC Small Cap Fund delivered the lowest of around 6.81% in the said time period. Nippon India Small Cap Fund, the largest fund in the category based on the assets managed, delivered 16.55% return in the last six months.Should investors wait for a correction or continue with SIPs?For investors who missed the recent rally, the sharp rise in small caps presents a dilemma. Entering after a strong run could expose investors to the risk of near-term volatility, while waiting indefinitely for a correction could mean missing further gains. Existing investors also need to decide whether recent gains warrant profit booking or whether they should continue with their SIPs.Naik said rather than viewing entry/exit decisions in isolation or based on absolute market levels, it is more effective to base them on your portfolio's allocation to small-cap stocks.For most investors, maintaining a small-cap exposure within 20–25% of their overall equity allocation is prudent and additionally, it may be advisable to build incremental exposure in a staggered manner over the next 6–12 months, he further said.Minocha said if investors have missed the rally, they should avoid rushing in as they have become very expensive. Likewise, waiting indefinitely for a perfect dip may not be practical and a gradual approach through SIPs is often more suitable, as small caps can be volatile and their valuations can change quickly.He further said that if investors already hold small caps, they should continue their SIP as long as allocation remains within their target range and there is no need to book profits solely due to recent gains. However, if holdings exceed planned allocation, consider trimming to maintain balance.ValuationsAccording to a report by Motilal Oswal Private Wealth, the Nifty is now trading at a 12-month forward Price-to-Earnings (P/E) ratio of 18.9x, which is 10% below its historical average of 21.0x. Mid and small-cap equities’ 12-month forward P/E trades at a 16%/33% premium to their 10-year averages of 24.0x/17.5x but the extent of the premium has come down compared to Sep’24.A report by PGIM Mutual Fund said that the valuation cushion sits in large caps. Mid- and small-cap selection still requires stronger earnings visibility and execution discipline. The one year forward P/E of Nifty Smallcap 250 is at 28.2x and small caps remain at meaningful premiums to both 5Y and 10Y averages.Also Read | Vikas Khemani’s Carnelian Asset Management files draft document with Sebi for its first fundWhat could drive the next leg of the small-cap rally?If small caps continue to outperform in the coming months, investors will want to know what could sustain the next phase of gains or what could be the key triggers driving the next leg of rally. While strong earnings have supported the recent rally, valuations are also higher, making future earnings delivery particularly important.Minocha said further progress will depend on clearer company results, stronger economic growth, stable domestic liquidity, lower interest rates, and sustained investor confidence and if earnings improve beyond large firms, small caps may benefit.However, the entry price will determine how much positive news is already reflected, Minocha further said.Naik said that small-cap earnings growth has been strong recently, which has led to relatively higher valuations and the key driver remains earnings growth, though input costs may play a significant role given the escalation of the US-Iran conflict.Small caps vs large and flexi capsIn the last six months, pharma & healthcare funds delivered the second highest average return of around 19.11%. Other diversified categories such as mid cap funds gave 10.74% average return, multi cap funds gave 10.01%. The flexi cap funds gave an average return of 6.20% and large cap funds were the only ones to end in red. The category was down 0.07% in the last six months.Small-cap funds can provide additional growth potential, but their higher volatility means they may not be suitable as the core of an equity portfolio. Investors therefore need to consider how much exposure they should have to small caps relative to diversified categories such as large-cap and flexi-cap funds.Naik said most investors should maintain their small-cap allocation within 20–25% of their total equity portfolio and the core of your equity allocation should remain in more diversified categories, such as flexi-cap, large-cap, mid-cap, and value funds.Minocha said investors should consider small caps as a supplementary position within an equity portfolio, not as the core holding and large-cap and flexi-cap funds provide balance and help manage risk, even though large-caps are badly hit in today’s markets.When appropriately sized, small caps can offer additional upside in the long run. In the near term, I would stay careful. The chance is still there, but after the recent rally, the main focus should be on steady, planned allocation, not on chasing what has already moved up, Minocha further said.Also Read | Edelweiss MF’s Altiva Equity Long Short Fund to launch September 10, Radhika Gupta explains strategyAccording to Motilal Oswal Private Wealth’s latest Alpha Strategist report, despite the improved backdrop, it retains a neutral view on equities. Its preferred equity exposure remains tilted towards mid and small caps, where it sees higher earnings growth and a stronger domestic backdrop supporting the investment case.“The recommended equity allocation remains at 40% Hybrid/Large Caps, 10% Global Equities and 50% Mid and Small Caps. For deployment, the firm recommends lump-sum allocation in hybrid strategies and staggered deployment in pure equity strategies. It also recommends using any sharp market correction to accelerate allocations.”(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)If you have any mutual fund queries, message ET Mutual Funds on Facebook/Twitter. We will get them answered by our panel of experts. Do share your questions at ETMFqueries@timesinternet.in along with your age, risk profile, and Twitter handle