Now that we are half way through FY06, it may be worthwhile to take a look at what domestic mutual funds have bought and sold during the period. Mutual funds rode to glory in FY05, on the back of a big rally in mid cap stocks.

However, with the market testing all-time high levels, there is a feeling in some quarters that mid cap valuations may be getting stretched in many counters. After a slew of mid cap fund launches early this year, there has been a number of large-cap fund launches in the recent months.

Are funds going back to large-caps as a defensive ploy or are they continuing to chase returns in an increasingly competitive world by sticking with mid-cap stocks?

For a better perspective let's look at the performance of how equity diversified funds have performed over the past six months. SBI [Get Quote] Mutual Fund's Magnum Sector Umbrella - Emerging businesses fund is the top performer in the equity diversified category during the period with a 51.98 per cent return.

The comparative Sensex returns amounted to 32.11 per cent. Prudential ICICI [Get Quote] Emerging Star fund (48.08 per cent), SBI Magnum Multiplier Plus (44.77 per cent), SBI Magnum Global fund (44.71 per cent) and SBI Magnum Sector Umbrella - Contra (43.45 per cent) were the other top performers during the period.

Mid caps on the wane?

Compared to the start of FY06, the dominance of mid-caps has surely waned. For example, While CNX Midcap 200 index was the biggest gainer for the 1-year and 6-months period ended - April 2005, they have slipped a bit since then.

As far as index returns go, sectoral indices like BSE Consumer Durable index (one year return of 100.63 per cent) and BSE Capital Goods index (94.51 per cent) and BSE Bankex (79.70 per cent) have outperformed CNX Midcap index (60.80 per cent).

The performance is even worse in the past half-year period. While BSE Small-cap index has dominated during this period with 80.20 per cent thanks to the huge rise in several penny stock counters, the returns of two mid cap indices, CNX Midcap (26.73 per cent) and BSE Midcap index (5.55 per cent) passes muster. Sensex returns for the past six-month period amounts to 32.11 per cent.

Looking at equity fund allocation patterns, it seems that at least some funds are cutting down on their mid-cap orientation. For example, the top performing equity diversified fund for the past year (return of 120.20 per cent) as well as the past six months, SBI mutual fund's Magnum Sector Umbrella - Emerging Businesses had a 46.88 per cent exposure to mid caps (CNX Midcap index) in September 2005, while in June the figure was 58.82 per cent.

Ditto with the next best performer, Prudential ICICI Emerging Star fund. This mid-cap fund had a mid-cap allocation of 50.83 per cent in March, but as on September the allocation has come down to 37.52 per cent.

SBI's other leading fund, Magnum Multiplier Plus has also reduced its exposure to the segment to 54.16 per cent, compared to 59.34 per cent in June. To cite one more example, another top performer from the SBI Mutual Fund stable, Magnum Global Fund's allocation to mid-caps have come down from 59.34 per cent in June to 54.16 per cent in September.

But that is only one part of the story. Considering that the mid cap segment has suffered a downturn in the recent past, it could also mean that the fund allocation to the segment could have come down because of the drop in prices.

A look at the trends of portfolio allocation reveal that while funds have benefitted form backing the right horse - read stock - they have also cut down on the risk factor by spreading their assets in more number of stocks.

For example, SBI Magnum Sector Umbrella - Emerging Businesses has Bharti Shipyard as its top holding (8.37 per cent), followed by Praj Industries [Get Quote] (5.93 per cent) and Welspun India [Get Quote] (5.82 per cent).

In March the fund did not have any holding in Bharti Shipyard and Welspun. As a diversification measure the fund has increased the number of stocks in its portfolio from 18 in March to 31 in September.

Similarly in the case of Prudential ICICI Emerging Star fund, it has increased its holdings in stocks like Deccan Chronicle and Subex Systems in the past six month period, which has propped up the fund returns. But as in the case of SBI's fund, here also the fund manager has increased the number of stocks in the portfolio from 42 in March to 50 in September.

Mid cap kicker

The kicker to portfolio returns still seems to come from the mid-cap segment. The returns in the top holdings of leading performers act as a justification of the stock picking abilities of the fund manager.

While the stock returns in top two holdings in SBI Magnum Sector Umbrella - Emerging Businesses, viz, Bharti Shipyard (a return of 179 per cent in the period between September and March), and Praj (128.50 per cent) have clearly inspired the good performances, in the case of Prudential ICICI Emerging Star fund, its top holdings in Deccan Chronicle (a return of 125.26 per cent over the past six months), Subex Systems (52.17 per cent) and Amtek Auto [Get Quote] (66.29 per cent) have boosted the returns.

On the other hand, some of the laggards in the past half-year have paid dearly for their faith in large cap stocks.

For example, Deutsche Alpha Equity Fund, which managed a return of 20.99 per cent in the six months-ended September, 2005 has its top holding in traditional favourites like Infosys [Get Quote] (5.96 per cent), Larsen & Toubro (5.37 per cent) and HLL [Get Quote] (4.29 per cent). The returns in these stocks in the past six months amount to 11.74 per cent, 52 per cent and 37.49 per cent respectively.

But there are worries about the high valuations in the mid-cap segment. Compared to the Sensex P/E of 17x, the mid cap index has a P/E of 19x. The stock prices of several mid-cap favourites have also run up quite high of late, thus limiting further upside potential in these counters, note analysts.

However, the very recent downturn in mid and small counters has corrected the situation to an extent. CNX Midcap index has lost 1.64 per cent in the past two weeks and 2.12 per cent in the past month.

According to Paras Adenwala, chief investment officer of ING Vysya Mutual Fund, valuations in many mid-cap stocks are getting corrected, because of the meltdown in stock prices.

Enter large caps

Keeping up with the times, select funds have been launching new schemes at capturing the opportunity in the large cap segment.

Birla Top 100 fund (will invest at least 65 per cent of its corpus in stocks of top 100 Indian companies as measured by market capitalisation), Principal Junior Cap fund (51 per cent will be invested in stocks that comprise the CNX Nifty Junior index), Principal Large Cap Fund {proposes to invest in stocks having a market capitalisation of more than Rs 3500 crore (Rs 35 billion)}, SBI Magnum Multi Cap fund (will invest 50-90 per cent in large-cap stocks), are some examples.

According to Principal PNB Mutual Fund, large caps add stability to the portfolio. Factors like long term viability of business apart from good corporate governance, high visibility and scalability of business reduces the risk element in large caps which makes them attractive propositions in an over heated market.

Hiking exposure

Suffice it to say that domestic equity funds, which have put their bets on mid-caps have outperformed others in this market. And the trend shows no sign of reversing. In fact, mutual funds are still making the biggest hike in terms of percentage allocation, to stocks in the mid-cap segment.

In the June-September quarter, mutual funds have increased their stake the maximum in Shree Ganesh Forgings [Get Quote], CCL Products Ltd and Rallis India [Get Quote]. While funds had no exposure to Shree Ganesh Forgings stock (the stock got listed only in June), total fund allocation has gone up to 13.47 per cent in the intervening months. The other stocks, which have seen the maximum rise in exposure are CCL Products (up 12.10), Rallis India (up 10.96) and Brescon Corporate Advisors [Get Quote] (up 7.99).

Interestingly, most of the stocks where percentage holdings have gone up the most are in the mid and small-cap space. Other counters, where exposure has gone up include Bharti Shipyard (up 6.97), Petron Engineering (up 6.91), Mid-day Multimedia [Get Quote] (up 6.86) and Emco (up 6.45).

However, funds are not completely avoiding large-cap stocks. Select stocks like Pfizer [Get Quote] (up 3.23), Punjab National Bank [Get Quote] (up 3.17) and Zee Telefilms (up 2.95) have also been favoured by domestic equity funds.

Four Soft Ltd [Get Quote], (down 10.32), Gateway Distriparks [Get Quote] (down 7.95), Mafatlal Industries [Get Quote] (down 6.04 per cent), Vardhman Polytex [Get Quote] (down 4.99) are the stocks where MF investments have gone down the maximum in terms of percentage of allocation. Other leading stocks where funds have cut exposure include Adlab Films (down 4.8), Federal Bank [Get Quote] (down 4.63), Provogue (down 4.56) and Geometric Software (down 4.06).

By the looks of it, fund managers are not unduly worried about the seemingly high valuations in mid-caps. Prashant Jain, chief investment officer of HDFC [Get Quote] Mutual Fund notes that select mid-caps continue to offer good investment opportunities.

"There is nothing wrong with a well managed growing business with competitive advantages even if it is small in size if the price is reasonable," says he.

However, fund managers are advising investors to tamper return expectations.

"The Sensex at present levels is trading at around 16 times estimated 1-year forward earnings. This indicates a reasonable outlook of the markets over the long-term given the secular growth prospects of the Indian economy. There is however a need to have more modest return expectations in the future as market returns should track earnings growth," says Jain.

Fund managers note that future kicker for fund returns will continue to come from the mid cap segment. "Even now, we believe that there is an opportunity in the mid-cap segment. Mid-caps should give perform better than large-caps over the next three-year period," says Adenwala.

While large caps may be a good idea to fall back on when markets become over heated, they are advisable for those who prefer to take a lesser risk on their portfolio. "Investors with a lesser risk appetite and who doesn't mind lower returns can go for funds with a large-cap orientation," says Adenwala.

Sectoral play

The opportunity in the infrastructure-related sectors like engineering, construction and travel, thanks to the higher government spending in the segment has surely has got mutual funds hooked.

Domestic funds have hiked their sectoral allocation the maximum to housing and construction segment during the past six months. Total fund holding in companies in the sector amounted to 2.65 per cent in March, while by September it has gone up to 4.31 per cent. The 1.65 per cent rise represents the biggest percentage rise as far sectoral allocation of funds is concerned during the period.

The next biggest rise is in the hotel & resorts sector (up 1.28 per cent) followed by engineering & industrial machinery segment (up 1.16 per cent). The other big movers are electrical & electrical equipment segment and transport & travel sector.

On the downside, funds have cut down in a big way in the hospital & medical equipment sector. While the fund allocation in the sector amounted to 5.77 per cent in March, 2005, it has come down to 2.59 per cent in September. Allocation to companies in the IT software & education has come down 1.98 per cent. Oil & gas sector (down 1.48 per cent) and banking sector (1.36 per cent) also saw a paring of fund exposure during the period.

However, it has to be noted that at an average of 9.71 per cent, IT software segment still rules the roost in terms of exposure to sectors. IT continued to be tops in March also at 11.69 per cent.