The outperformers

Overall, nearly 59 per cent of diversified funds has outperformed the Sensex for the past one-year period. Over a three-year period the performance of the funds is even more impressive. A whopping 91 per cent of equity funds has outperformed the Sensex during the period.

Among funds with more than Rs 100 crore corpus, SBI Mutual Fund's Magnum Global Fund was the best performer for the 12-month period ended June 30, 2005. The fund managed returns of 111.21 per cent. The next best performer was also from the SBI Mutual Fund stable - Magnum Sector Umbrella - Contra which managed 98.87 per cent returns. Other top performers included Reliance Growth Fund (93.23 per cent), Sundaram Select Midcap (88.83 per cent) and Franklin Prima Fund (74.83 per cent).

Fund managers note that the general well being of equity markets has rubbed off on equity funds. "The upswing in the general market sentiment has helped equity fund performances over the last couple of years. There has been a tremendous interest in Indian equities from foreign investors, while domestic retail participation has also increased, notes Paras Adenwala, chief investment officer (equity markets), ING Vysya Mutual Fund.

Mid-cap mania

to achieve their returns. Several funds have a mid-cap mandate. Even otherwise, funds have preferred the higher risk-higher return formula in mid-cap stocks in the past year. "Equity funds have gained tremendously from their exposure to mid-cap stocks, which have done much better than large-caps in the past year or so," notes Adenwala.

For example, the top-performing SBI Magnum Global Fund has a 55.44 per cent exposure to the CNX Midcap 200 Index as of June 30, 2005. Other big gainers like Tata Growth Fund (45.97 per cent), Reliance Growth (46.61 per cent), Alliance Equity Fund (37.10 per cent) and Franklin India Prima Fund (61.47 per cent) have also followed suit.

But the high exposure to mid-caps has not been without reason. Fund managers seem to have realised early during the bull rally, that the mid-cap segment is where the big gains are going to come from. With most large-caps already running high and considering the re-rating potential of many stocks in the midcap segment, their choice was but natural.

The benchmark index for the mid-cap segment, the CNX Midcap 200 Index was the best performer among broader indices in the past year. The index gave a return of 96.30 per cent for the year ended June 30, 2005, much better than the 50.01 per cent managed by the Sensex and the 47.49 per cent by the Nifty.

In fact, the CNX Midcap 200 Index was the second best of all the indices (including sectoral indices) behind the BSE Consumer Durable Index (123.20 per cent) for the year. The former is in fact the best performing index for the past two-year period with returns of 74.93 per cent.

Many mid-cap funds have assests as big as large-cap schemes. But liquidity in mid-caps is only about 16-17 per cent of that in large-caps

However, if recent trends are to be believed, the mid-cap mania seems to be coming to an end - to an extent, at least. Fund managers are decreasing their exposure to the mid-cap segment, keeping in mind rising valuations and lack of liquidity in many counters. The CNX Midcap 200 Index has a P/E in the mid-20s compared to 15 for the Sensex. This means that fund managers will be paying a higher price, and keeping in mind the lack of liquidity that is a big risk to take on their books.

The problem is that liquidity in mid-caps is only about 16-17 per cent of that in large-caps. The total market capitalisation of large-caps (say, above Rs 1,500 crore) is around Rs 15,81,420 crore, while that of mid-caps (say, Rs 100-Rs 1,500 crore) is about Rs 2,61,771 crore. And only half of it is free float. "It is difficult to say at this point how this boom in mid-caps is going to pan out," says a fund manager. "Let me put it this way. These days the size (assets under management) of mid-cap funds is getting larger and many of them have AUMs as big as large-cap funds (for example, Franklin Prima Fund, a predominantly mid-cap fund, has an AUM of Rs 1,617 crore, while Franklin's large-cap fund, Franklin India Bluechip Fund has a size of Rs 1,609 crore). So when a mid-cap fund of a size of Rs 15,000 crore wants to invest 5 per cent in a mid-cap stock of Rs 1,500 market cap, it is owning nearly 5 per cent of the stock itself. The higher exposure will mean that the fund will also be exposed to higher liquidity risk if the market goes down," says the fund manager. Keeping in mind this risk, the recently launched HSBC Midcap Fund kept an upper limit of Rs 700 crore to its AUMs. Another fund which has taken the same route is Reliance Growth Fund, which is planning to suspend sales in the fund for three months. According to the fund, the move was to protect the interest of existing investors in the fund in view of the increasing fund size and to facilitate better performance. The Reliance Growth Fund currently has a corpus of Rs 1,322 crore. The suspension will take effect when the fund's corpus reaches Rs 1,700 crore or August 14, 2005, whichever is earlier.

Cutting down on mid-caps

Index funds performed better than actively managed ones in US. But the situation is different in India

The US example

John C Bogle, in his book, Common Sense on Mutual Funds notes that the S&P 500 returns lagged the equity fund average in only three phases in a period spanning 1963 - 1998. And even in these three periods - 1965-1968, 1977-1980, and 1991-1993 - it was the appreciation small- and mid-caps that led to the outperformance by the funds.

So are Indian funds heading the same way? Not if you believe domestic fund managers. According to them, there are differences between the US and Indian scenario.

"Though US fund history tells us that index funds have performed better than the actively managed funds, the situation in India is quite different. I don't think we have reached a stage where people have lost faith in actively managed funds," says Pathak. The difference in the overall economic scenario also makes it difficult to compare the two markets, say analysts. "In the US, there was a saturation of growth and opportunities. In a highly evolved market like the US, which has any number of good fund managers, it becomes difficult to pick a big winner," notes Pathak.

According to Adenwala, the lack of opportunities for growth gets reflected in the performance of the US equity funds. "That way outperformance is difficult for these funds. However, in comparison, in India, almost every sector is likely to witness a huge growth going forward." But while that may be true, considering the frenetic pace of growth that is being predicted for India, it is a moot point that the Indian fund scenario would follow suit, sooner or later. But fund managers are confident that it is not going to happen in a hurry. "I don't expect India to reach that stage in the next five-10 years at least," says Pathak.

There are several reasons for their confidence. The percentage of US households that invest in funds has risen from 6 per cent in 1980 to more than 50 per cent currently. In India it is still a negligible percentage, which means that to achieve a meaningful comparison with developed markets, we still have a long way to go. "Diversified funds will continue to do well for a few more years. I think Indian markets are evolving and there are opportunities waiting to be tapped. We see the trend of a lot of long-term players entering the markets," says Pathak.

Fund managers note that Indian markets are coming out of their shell. Considering that Indian economy is likely to grow by 7-8 per cent over the next few years, markets should see a sustained growth. Also, with corporate earnings expected to be around 15-20 per cent, equities are likely to better that returns."Equity fund performance is a derivative of corporate performance. As companies were able to post substantially high profits, partly due to their lower base, funds have been able to ride piggyback on them," notes Adenwala.

While fund managers are under pressure to increase their asset base, they are confident of giving reasonable returns in the long term

While fund managers are under pressure to increase their asset base, they are confident of giving reasonable returns in the long term. However, they warn against high expectations. "Investors should not expect equity funds to give 90-100 per cent returns every year. Broad markets should give a CAGR return in the range of 12-15 per cent over the next two-three years," notes Pathak.

With opportunities in the broad market tapering out, funds are dependent on the stock-picking abilities of fund managers. "I think it is becoming a stock pickers' market. If we identify good companies which have the opportunity and potential to grow, fund managers will continue to outperform the markets," notes Pathak.

But fund managers are guarding against taking sectoral bets. Nilesh Shah, chief investment officer of Prudential ICICI Mutual Fund, believes that the days of sector-specific rallies are over. While they are bullish on sectors like banking, infrastructure-related and consumer-dependent sectors, caution is advised in taking big sectoral bets.

So what will drive equity returns this year? "I expect a re-rating of Indian equities to happen soon. In many cases it has already started," says Pathak. Fund managers also expect the mid-cap segment to do well, though they agree that returns may not match that of last year. Pathak is of the opinion that mid-caps will continue to see good growth going forward. "Though there are some stocks which have become overheated, the universe of mid-caps is still pretty large, and it is possible to find 30-35 good stocks in the segment for your portfolio," says he. "I would back them to do better than large-cap stocks in the longer term," adds Adenwala.

Overall, fund managers continue to be bullish on equities, though they warn against big return expectations. But rest, assured, if fund managers are to be believed, they will continue to give better returns than other asset classes. "I think at least for the next five-10 years, diversified funds will continue to outperform the markets, concludes Pathak