Why 2026 small & midcap rally isn’t out of steam yet as fund flows shift from heavyweights

The Indian equity markets have not had the best runs lately. Multiple headwinds, such as higher crude oil prices, elevated US bond yields, persistent selling by foreign investors, and the global artificial intelligence-led trade clouded the outlook.

Amidst this backdrop, investors have rotated funds towards mid- and small caps from heavyweights. Sectors with high growth opportunities from the government’s policy thrust have witnessed a bulk of these flows. These include defence, capital goods, renewable energy, and pharmaceuticals, according to analysts.

Around Rs 2.8 lakh crore has gone into small and midcap mutual funds since 2024. Midcaps’ earnings have generally outperformed Nifty 50 companies over previous quarters and hence have attracted flows.

“The beneficiaries (from the sector rotation) are companies that are part of high-growth sectors. Such stocks generate interest among investors, who then partially switch their holdings from stable stocks (heavyweights) to those offering superior earnings visibility,” said Saurabh Prasad, Head – Research Centre at Mirae Asset Sharekhan.

Investors would selectively be investing in the market segments with better growth prospects and high earnings visibility even at slightly elevated valuation, Prasad added.

Shrikant Chouhan, Head Equity Research at Kotak Neo identified defense and aerospace, capital goods, electronic manufacturing services, and renewable energy as some of sectors seeing investor interest. “The government’s manufacturing and localisation focus (especially in electronics, semiconductors, and defence) has shifted focus on these sectors,” Chouhan said.

A big chunk of the capital is also rotating out of index heavyweights and into the healthcare and other capital expenditure-linked sectors.

The pharmaceutical sector and healthcare are the only ones that have delivered double-digit returns in 2026 as of October 9, said Krishna Rao, MD & Co-Head – Equity Broking at JM Financial Services. This indicates a pronounced shift towards defensives.

“Capital Goods (+9.2%), Metals (+7.5%), Media (+7.5%) and Power (+7.4%) have also moved into positive territory, reflecting a preference for domestic investment and commodity-linked themes,” Rao added. “By contrast, IT (-24.6%), FMCG (-19.1%) and Oil & Gas (-15.9%) have underperformed the Sensex (-15.0%), largely owing to their high FII ownership,” he said.

Defence manufacturing in the country has risen over Rs1.5 lakh crore now from around Rs. 46,000 crore in FY15, led by both import substitution and a rising export opportunity. “Select pockets in capital goods benefited from the government’s increased emphasis on capital expenditure and a rise in private sector capex too. Given the policy push on clean energy, renewables and associated distribution/transmission infrastructure are also likely to be decadal opportunities,” Mirae Asset’s Prasad said.

JM Financial’s Rao said this year’s data points to a “decisive” shift in market leadership towards the broader market. As of October 9, the NSE SmallCap Index is up 8.1%, while the Nifty is down 13.8% and the NSE Midcap Index has declined by a modest 2.8% in 2026.

Rao said the principal driver of this shift is earnings growth. Small and mid-cap (SMID) companies are expected to deliver stronger earnings growth than large-cap heavyweights, and their exposure to global themes offers a long runway for expansion.

“SMID names linked to data-centre capex, power equipment, and cables and wires are among the market’s best performers, as rising infrastructure spending is lifting order inflows and earnings,” he added.

Prasad said the ongoing rotation, especially towards midcaps, is supported both by flows and earnings growth.

“The ongoing market volatility is partly due to FII (foreign institutional investor) selling, countered by sustained DII (domestic institutional investor) buying. However, if we delve deeper, we note that FII selling is concentrated in large-caps, whereas DIIs could be more active in broader markets,” Prasad added.

Vinod Nair, Head of Research at Geojit Investments said the mid- and small-cap rally of 2026 has narrowed recently following profit booking, bringing their performance closer to large-caps.

“Large caps have gained traction lately on expectations of relatively stronger Q2 earnings, attractive valuations and greater resilience to rising external headwinds. This has encouraged value buying across IT, FMCG, financials and chemicals, despite near-term profitability remaining subdued,” Nair said.

He added that interest in SMID companies has now become increasingly selective, with valuations driving opportunities in “specific stocks.”

Analysts have selected defence, banking and financials, pharmaceuticals, and IT as the key sectors to keep a watch on for the next six to 12 months. For both financials and technology, earnings delivery is a key anchor, and FII inflows would act as the catalyst for outperformance to broader markets.

“Short-term calls are normally tactical calls, and we believe the financials and IT sectors are better suited to outperform. Both have faced significant FPI selling and now offer a more attractive risk-reward compared with recent years,” said Mirae Asset’s Prasad.

“The financials sector is a more fundamental call as system credit growth is in healthy double digits, and asset quality remains good. Consequently, earnings would be supported both by rising advances and benign credit costs. Improving earnings trajectory with reasonable valuation should provide a greater margin of safety and result in outperformance.

Technology, meanwhile, is more of a tactical call. Earnings growth have stabilised after a period of downgrades. AI is emerging both as an opportunity and a threat, depending upon the business profile. Additionally, there could be some portfolio rotation from the partial unwinding of AI trade in other emerging markets,” Prasad added.

Geojit’s Nair said defence, pharmaceuticals, capital goods and renewable power remain relatively well positioned, supported by stronger earnings visibility and structural growth drivers.

Kotak’s Chouhan prefers defence and private banks. Indian banks will be supported by improving credit growth, stabilising margins, moderating credit costs, and healthier asset quality.

Moreover, improving earnings of private lenders, attractive valuations, and easing management-transition concerns further strengthen the sector’s risk-reward profile.