valuations: Popular mid-cap funds struggle to keep pace with runaway benchmark

Mumbai: Mutual fund schemes betting on mid-cap stocks, one of the most popular product categories of late, have struggled to beat their benchmarks over the past three years. Out of the 25 schemes investing in mid-cap stocks, only five have managed to beat the Nifty 150 Midcap index. Analysts and investment advisors say the inability to deploy the continuous flows into these schemes and increased exposure to blue chips, with valuations of mid-cap stocks remaining elevated, have led to the underperformance.

Data from Value research show that the actively-managed mid-cap fund category has generated an average return of 25.36% against the Nifty 150 Midcap index return of 27.08% over three years.

“With high inflows into mid-cap stocks over the last few years, market efficiency within mid-caps have improved a lot. This means that there is less room for active managers to find mispriced stocks and generate alpha,” says Kunal Valia, founder, Statlane, an investment advisory firm.

Mid-cap funds saw net inflows of ₹24,440 crore in the last 12 months compared to ₹34,386 crore into small-cap schemes and ₹7287 crore into large-cap schemes.

Mid-cap funds need to hold at least 65% of their corpus in stocks ranked 101-250 by market capitalisation. The rest 35% is at the fund manager’s discretion.

Analysts said fund managers also cut exposure to some of the overheated stocks in the mid-cap category, which have continued to run up, and stayed away from companies deemed to be of poor quality, contributing to the underperformance.”Limitations in terms of ability to take exposure to some of the low quality stocks in mid-cap index besides managing large inflows in bull markets have led to the underperformance of active mid-cap funds,” says Vidya Bala, founding partner, Primeinvestor.in. The continuous money flow into equity mutual fund schemes including mid-caps has helped the market move from strength to strength despite growing concerns that the valuations of smaller companies are heated.

The Nifty Midcap 150 index trades at a Price to Earnings (PE) ratio of 44.2 times compared to its five-year average PE of 28.32.

The index has gained 27% so far in 2024, 50.21% in the past year and 105% in the past three years. The Nifty has risen 15.22%, 30.74%, and 47.97%, respectively, during these three periods.

Active or Passive Mid-cap funds?
Valia said the higher expense ratio of actively-managed mid-cap funds relative to index funds is also a reason for the underperformance.

For some wealth managers, actively- managed funds remain better options in a hot market.

“Currently, we are in a phase of the market where there is a broad-based rally but the euphoria in some segments of mid- and small-cap stocks and risk is being ignored,” says Ashish Shankar, CEO, Motilal Oswal Private Wealth. “I would still go with active funds as they are better positioned to manage risk.”

Bala advises investors to hold a mix of active and passive mid-cap funds in their portfolios. “This will ensure they are riding with the market at all times and generate meaningful alpha,” she said.