Mid-cap funds have been in the limelight for some time now and not without reason. They have been among the best performers in the equity diversified category, which has resulted in a spate of launches in their category as more funds rushed to join the bandwagon. There is one hitch though.

As these funds grow bigger and bigger in size - as more and more investors come in - too much money is chasing too few stocks. It suffices to say lower number of quality stocks, higher valuations and lack of adequate liquidity are posing a threat to the mid-cap boom.

There is another problem, too. These funds haven't really been outperformers when you pit their returns against their generally accepted benchmark index, the CNX Midcap 200 Index.

Thus, considering the current uncertain market trends with index returns going down, there are doubts about the logic of investing in the mid-cap segment. Some fund managers have expressed concerns about this mania towards mid-cap investing which could turn out to be scary if things go wrong.

"It is difficult to say at this point how the boom in mid-caps is going to pan out," says a fund manager with a leading domestic mutual fund, who doesn't prefer to be quoted.

More expensive and less liquid

Indeed, mid-cap stocks are expensive than large-caps right now. The CNX Midcap 200 Index currently has a P/E of 18. 38, which is higher compared to the Sensex (15. 31) and the Nifty (15. 15).

Though some analysts have noted that the potential for higher growth still makes mid-caps very attractive, the flip side is that when the fall comes, it will be the mid-caps which will be hit the hardest.

Recent example is the IT boom during the late 1990s when people were betting on huge growth rates, despite the very high valuations in tech stocks at that time. What happened post-2000 is still too fresh in memory.

Though they have been better performers as a category compared to large-caps - the CNX Midcap 200 Index gained 10. 21 per cent in the past three months while both the Sensex and the Nifty barely avoided negative returns - the higher risk involved in mid-caps and issues about liquidity are a cause for concern.

While the low price has helped many stocks in this segment give super-normal returns as the markets witnessed a secular bull run, it stands true that when the market falls they will be affected the most.

The problem is that the liquidity in mid-caps is less than a fifth of that in large-caps. The total market capitalisation of large-caps (say, above Rs 1,500 crore) is around Rs 14,07,400 crore (Rs 14,074 billion), while that of mid-caps (say, Rs 100-1,500 crore) is about Rs 2,52,585 crore (Rs 2,525.85 billion). And only half of it is free float.

These days the size (assets under management) of mid-cap funds is getting larger and many of them have AUM (asset under management) as big as large-cap funds.

For example, Templeton Mutual Fund's Franklin Prima Fund, a predominantly mid-cap fund, has an AUM of Rs 1,498 crore (Rs 14.98 billion), while its large-cap fund Franklin India Bluechip Fund has a size of Rs 1,585 crore (Rs 15.85 billion).

So when a mid-cap fund of a size of Rs 1,500 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," explains a fund manager. Keeping this risk in mind, the recently launched HSBC Midcap Fund had kept an upper limit of Rs 700 crore (Rs 7 billion) to its AUM.

The burgeoning interest

"There is a lot of interest in the mid-cap segment right now. The interest is coming from across investor segments, be it FIIs, hedge funds or retail investors," notes a fund manager.

The good run in the mid-cap segment has also given rise to a spate of fund launches in the segment. Tata Mutual Fund's Tata Midcap is the latest to be launched, while it was preceded in the previous months by Kotak Midcap, SBI [Get Quote] Magnum Midcap, Sahara Midcap, Chola Midcap, Sundaram SMILE, HSBC Midcap and ING Vysya Midcap.

While funds are busy propagating the potential of stocks in small- and mid-cap segments to become large-caps in the years to come - providing investors with super returns in the process - it remains to be seen whether mid-cap funds will be able to withstand any downturn in the market sentiment. The good thing is that funds have been able to take advantage of the good market sentiment till now.

"As of now, mid-cap funds are performing well and have managed to give better returns than diversified funds," says A K Sridhar, chief investment officer of UTI Mutual Fund.

The CNX Midcap 200 Index has by far been the best performer compared to other broader indices. While the index posted a 12-month return of 83. 60 per cent, the Sensex and the Nifty managed 31. 26 per cent and 29. 77 per cent during the same period.

But the mid-cap index has been on the decline over the course of the year. Though it is still ahead of other indices, returns for the six-month period came down to 32. 39 per cent, while in the past quarter the index returns were at 10. 21 per cent.

Behind the benchmark

Interestingly, mid-cap funds have not been able to keep pace with their benchmark indices, with the average category returns amounting to 65. 24 per cent. Diversified funds managed 46. 46 per cent during the same period.

In fact, no mid-cap fund has managed to outperform the CNX Midcap 200 Index. Fund managers point to the technical issues in managing a 200-stock portfolio (as the index suggests) for the underperformance.

So even as the mid-cap index returns look very impressive, the pay-offs in mid-cap funds may not be as high as they lag behind the benchmark.

To tide over the higher risk in the mid-cap segment, fund managers are adopting a cautious approach. According to Sridhar, the universe is so large in the mid-cap segment that it is best to stick to fundamentally good companies.

"The risk in mid-caps is higher than that in diversified funds. I may not be able to capture the momentum in every stock, but by sticking to fundamentally good stocks, I will be able to insulate myself from the downturn in the market sentiment to a large extent. We prefer companies which are high on quality or are turnaround stories."

In an effort to keep pace with the changing market scenario, mid-cap funds have been churning their portfolios quite a bit.

For example, Birla Midcap Fund's April 2005 portfolio shows Tata Elxsi [Get Quote] as its top holding while the March topper, McDowell has been pushed down to the third position.

Cholamandalam Mutual's mid-cap fund has reduced exposure to IVRCL Infrastructure, while increasing exposure to Hexaware Technologies [Get Quote].

While Kotak Midcap Fund has reduced exposure to Dhampur Sugar Mills [Get Quote], Gujarat Narmada Valley Fertilisers and Punjab National Bank [Get Quote] (PNB) in its latest portfolio (April 2005), Reliance [Get Quote] Growth Fund has booked profit in Satyam [Get Quote] Computers.

The churning patterns make it clear that fund managers are getting out of or reducing exposure to stocks which have already gone up too high in the past year. For example, IVRCL's stock has appreciated by nearly 145 per cent, while Dhampur Sugar has seen a 247 per cent rise in stock price.

According to Anil Sarin, senior equity fund manager at Prudential ICICI [Get Quote] Mutual Fund, the stock selection in mid-caps is even more 'bottom-up' than in a diversified fund.

"It is unfair to paint all mid-cap stocks with the same brush as they belong to different industries," notes Sarin.

"For example, suppliers currently enjoy better valuations than principals. This is especially true in the case of auto (principals) and auto ancillary companies (suppliers). While stock selection is a fund manager's headache, investors looking for higher returns are bound to be lured by the hype surrounding mid-cap funds. While no one can doubt the potential for higher return in this category, fund managers remain cautious.

"Even though the mid-cap segment has been giving good returns, investors should keep in mind that there is a fair amount of risk involved there," notes Sarin.

Take the rough with the smooth

So how should one approach investing in mid-caps? According to Sarin, mid-cap funds should be treated as other sectoral funds where investments are generally advocated over and above diversified equity funds.

"Investors should not make them the main focus of their portfolio," says Sarin.

"Our advice to investors is to put only that much money into mid-cap funds that one doesn't have to worry about."

According to one fund manager, despite the higher returns in the mid-cap segment for the time being, the gap in returns between large-caps and mid-caps over a longer tenure will not be very significant.

"Also, when the markets reverse direction, investors will also feel the pinch on the liquidity front and the erosion on capital will be higher," he warns.

Interestingly, some of the funds who propose to invest across market capitalisations and with a mandate to go higher either way (large-cap or mid-cap), depending on the market condition, are leaning more and more towards large-caps.

But Sarin is quick to point out that rewards will be handsome for those who are prepared to ride the highs and lows of mid-cap investing."The big boom in the mid-cap segment is not a bubble," assures Sarin.

"Earnings prospects of many mid-cap companies are improving. Valuations in certain stocks are very attractive," he says. However, there are others who paint a different picture.

"The problem with mid-cap stocks is that even if they grow big on a one-year time frame, the growth rates cannot be sustained for a long time," says a fund manager.

Fund managers note that if you are investing in mid-cap funds it is better to do so with a perspective of one-year and above; if not, it is time to book some profits.