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Shanthi Venkataraman

MUTUAL funds seem sold on the mid-cap bug. Over the past year, mid-cap funds have been in the limelight, even as diversified equity funds fervently packed their portfolios with relatively smaller stocks. Many fund houses have in recent months announced the launch of mid-cap funds to capitalise on the rally.

Even relatively conservative funds such as HSBC Equity believe that opportunities lie only in under-researched stocks. UTI Mid-Cap and Prudential ICICI Emerging Star fund are some of the recent launches, while ING Vysya and JM Mutual fund will soon launch mid-cap funds as well.

The entry of more mid-cap funds would broaden the `choice-set' for investors who wish to enhance exposure to mid-cap stocks. Over the years, there have been only a handful of such funds, the prominent ones being Franklin Prima, Sundaram Select Mid-Cap, UTI Mastervalue and Birla Mid-Cap.

The performance of such funds has also encouraged investors to seek exposures to mid-caps over the past year. While these funds have not necessarily outperformed the CNX Midcap 200 in bull phases, they have done better in correction periods.

The corpuses of funds such as Franklin Prima and Sundaram Mid-Cap have grown considerably over the year.

Sundaram Mid-Cap, a Rs 30-crore fund in September 2003, now has an asset base of Rs 140 crore. Only a part of this growth is explained by the rise in its net asset value (NAV).

Prima's asset base has burgeoned from Rs 350 crore to Rs 850 crore over the period. Their large-cap counterparts, Sundaram Growth and Templeton India Growth, have not attracted as much inflow over the same period.

Keeping pace with the Midcap 200

The CNX Midcap 200 would have proved to be a rather difficult benchmark to beat for most mutual funds in the past year. The mid-cap rally gained momentum around September 2003. Between then and now, the index has appreciated more than 85 per cent. Even the S&P CNX 500, which captures a larger cross-section of the market and is by no means an easy benchmark to beat, gained only about 50 per cent over the period.

Business Line analysed the performance of the handful of mid-cap funds from September 2003. Included were funds such as HDFC Tax Plan 2000 and Prudential ICICI Tax Plan, which are not specifically positioned as mid-cap funds, but invested predominantly in mid-caps. The majority of large-cap focussed equity funds outperformed the bellwether indices such as the Nifty and the Sensex. But, for mutual funds with a mid-cap focus, beating the mid-cap index was not a cakewalk.

Few mid-cap focussed funds were able to keep up with the scorching pace of the Midcap 200 Index over the past year. Only HDFC Tax Plan 2000, Franklin Prima and Sundaram Select Mid-Cap outdid the index over the time-frame.

Coping with volatility

Mid-cap funds may perk up overall returns, but they also come with a higher risk profile, as they tend to be more volatile than large-cap stocks. While they rise steeply in a bullish phase, they tend to take harder knocks during a correction period.

The rally in mid-caps has seen bouts of "correction" periods, when the index fell steeply (see graph), dragging down mutual fund performances with it. From its peak in January, the Midcap 200 fell 21 per cent before recovering once again in March. During the same period, the Nifty fell by only 14 per cent.

Fund performances were, therefore, compared over various peaks and troughs of the midcap rally. Across various phases between 2003 and 2004, only two or three were able to beat the index during an uptrend. Prima, Sundaram Mid-Cap and PruICICI Tax Plan, to some extent, were able to emerge at the top of the rankings during a rally.

Handling the correction well

The good news is that the mid-cap funds handled the market corrections better. For instance, during the correction phase between January and March 2004, mid-cap funds, barring PruICICI Tax Plan, checked the decline in NAVs to less than 20 per cent, while the Midcap 200 fell 21 per cent.

The ability to handle the volatile phases is crucial to a mid-cap fund's performance. For instance, HDFC Tax Plan 2000 lagged the benchmark index by a good margin during the rallying periods. But it also suffered the least declines during market corrections.

As a result, its overall return during September 2003-November 2004 is 98 per cent, which beats even Franklin Prima, a top performing mid-cap fund.

Varying performance across phases

Different funds have floated to the top at different phases of the market rally. For instance, Prima was the top-performer in the late 2003-early 2004 rally, but it underperformed the Midcap 200 in the recent rally. PruICICI Tax Plan, on the other hand, suffered sharp declines in the early part of the year but bounced back smartly June onwards.

The variation in performance between funds and across phases could be attributed to the kind of sectors and stocks these funds chose to take exposures in. Prima, for instance, had large holdings in the auto and commodity sectors in late 2003, when these sectors were the main beneficiaries of the mid-cap rally. It, however, missed out on the rally in engineering stocks over the last couple of months.

Birla Mid-Cap has been an underperformer over the past year, largely because it stayed away from the rally in such sectors as fertiliser and sugar and stuck to non-cyclical stocks. This strategy did, however, pay off in correction periods, when it contained the fall in NAVs fairly well.

The time-frame for this study is not long enough to draw inferences on matters such as the importance of timing one's investment in mid-cap funds or choosing a fund that protects downside risk. But it does highlight the differences in investment strategies of funds, which has a direct bearing on their performance.

Investing in mid-cap funds

Mid-caps today, large-caps tomorrow. The idea of discovering an under-researched stock that will appreciate substantially to the extent of becoming a large-cap appears to be the main selling point of mid-cap mutual funds. The idea is not so far-fetched, as many so-called mid-cap companies are starting to attain large-cap status.

Mahindra and Mahindra, for instance, which figured in Prima's portfolio last September, would find no place in any truly mid-cap fund now. Stocks such as Raymond, Monsanto and Indian Rayon, which had a market cap of Rs 800-1,000 crore last year, are now approaching a market cap of Rs 2,000 crore.

It is now becoming essential to have mid-caps in your portfolio. Mid-cap funds have certainly done better than their large-cap counterparts. For instance, Prima and Sundaram Mid-Cap recorded returns of 56 per cent and 45 per cent over the year, against the 31 per cent returned by Franklin Bluechip and Sundaram Growth Fund.

This could be reason enough for you to want to invest in a mid-cap fund. Here are a couple of pointers before investing in mid-cap funds:

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