Mid-cap funds have always evoked a sense of caution in the minds of investors. These funds are deemed quite volatile and unsuitable for those with an average risk appetite, as they invest predominantly in stocks with less than Rs 7,500 crore market capitalisation. But contrary to the general perception, mid-cap funds have done quite well vis-à-vis their benchmarks over the last 4-5 years.

Consider this: Over the last three years, six out of every 10 mid-cap funds have outperformed indices such as the S&P CNX-500 and BSE Midcap. And the scorecard gets even better over two- and one-year time-frames, with four out of five and two out of three funds outperforming the indices in the said periods.

Interestingly, the number of funds focussed on mid- and small-cap stocks has increased from 27 in 2006 to 45 currently. What's more, returns of mid-cap funds have matched or outperformed CNX Nifty and large-cap funds over one-, two- and three-year periods. For example, over the last three years, the mid-cap fund category average returns, at 8.5 per cent (compounded annually), is better than the large-cap fund universe's average returns by a couple of percentage points. And if a two-year time-frame is taken, at 21.5 percent, the mid-cap funds have beaten both the Nifty and the large-cap funds' average returns by 5-6 percentage points.

However, as a category, the returns of mid-cap funds lagged both Nifty and large-cap funds over longer time-frames of 4-5 years. This dubs their performance relatively plain in comparison with large-cap funds given their riskier mandate and lower returns.

This, however, isn't reason enough to do away with mid-cap funds as some have surprised positively on the returns front. The trick, therefore, is to select the right mid-cap fund and time the investment correctly. Here, we look at the performance of mid-cap funds to find out the best investment bets in their category.

Improving performance

Mid-cap funds are relatively new entrants in the mutual fund industry, with only 27 of them having five-plus years in operations.

But, of these, as many as 10 have performed consistently across market cycles. This means only 10 funds participated well during market upswings and contained downsides reasonably well. If a three-year period is taken, that number goes up to 14.

Some of the funds that delivered over the long term include IDFC Premier Equity, HDFC Mid-cap Opportunities, Sundaram Select Midcap, ICICI Pru Discovery and DSPBR Small and Midcap.

The laggards include: HSBC Mid-cap Opportunities, JM Emerging Leaders, SBI Magnum Midcap, BNP Paribas Midcap and ICICI Pru Emerging STAR.

The difference between the winners and laggards has been determined by how much the NAV of funds fell during 2008-09 and to what extent they were able to participate in the subsequent recovery.

In this regard, some funds saw NAVs plummet 70-86 per cent in 2008-09. So, even a 200 per cent return in the rally that followed was not enough to play catch up — cases in the point being Taurus Discovery, JM Emerging Leaders and BNP Paribas Mid-cap.

But funds such as Canara Robeco Emerging Equities and Magnum SFU Emerging Business did fall heavily, though they recorded more than 260 per cent returns between March 2009 and November 2010.

Sector selection, key

The best performing funds mentioned earlier had straddled the right sectors across market cycles. For example, the likes of IDFC Premier Equity, HDFC Mid-cap Opportunities and DSPBR Small and Mid-cap made top investments in sectors such as banks, consumer non-durables, pharma, software and auto. These funds invested 10-20 per cent in each of these sectors from 2008 and have more or less maintained prominence to these sectors.

All these sectors, except banks, fell less than the broader markets in 2008 and thus provided some cushion from the market carnage, thanks to their tag of being defensive then. But in the subsequent rally, all these sectors had a phenomenal run and turned out several multi-bagger stocks.

Even in the present volatile markets, many of these sectors continue to hold on, despite higher valuations, as they continue to have relatively sound earnings visibility.

The funds that suffered the most were those that continued to dabble in sectors that were the favourites in the 2007 rally. These included construction, capital goods, textiles and even media and entertainment. These sectors witnessed a battering at the markets, thus dragging down the performance of funds such as HSBC Mid-cap Opportunities, SBI Magnum Midcap, JP Morgan India Smaller Companies and Taurus Discovery. Some funds such as ICICI Pru Emerging STAR also invested over 20 per cent of the portfolio in derivatives during late 2008 which may have dented NAVs.

Another notable aspect was that the outperformers had taken cash positions of anywhere between 10-25 per cent of their portfolios during instances of market volatility.

Best investment bets

Despite the category failing to beat large-cap funds, there are individual funds that can deliver steady returns.

Funds such as Sundaram Select Mid-cap, ICICI Pru Discovery, Reliance Regular Savings and IDFC Premier Equity, which have five-year track records, have delivered compounded returns of 17-28 per cent, matching that of best large-cap funds.

Others with a 3-4 year track record, such as HDFC Mid-cap Opportunities and DSPBR Small and Midcap too, delivered robust returns, bettering the bellwether indices such as the Sensex and Nifty. Each of these funds has followed one or more of the portfolio moves mentioned earlier to optimise returns, in an adept way in fast changing markets that were 2008-2010.

Investors can choose these funds as a means of diversification and especially take the SIP (systematic investment plan) route to taking exposure for furthering portfolio returns.

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