Mid caps generally tend to outperform large caps when the rally is sustained and valuations get stretched in large cap. Over last couple of months, markets in India have rallied shrugging off negatives such as falling rupee and slower growth. While rupee recovered smartly from its lows, economic growth has remained subdued. But globally the sentiment is blissful. Continuation of the current pace of quantitative easing programme in the U.S. and robust Chinese economic data has been driving global equity markets. Country's one of the most tracked indices, S&P BSE Sensex went up about 12% over last 2 months and similar returns have been generated by CNX Midcap Index.

Now that S&P BSE Sensex has hit a psychological mark of 21,000; everybody has become sceptical about the future course of markets. But if we look at it from market capitalisation segmentation, it is noteworthy that mid caps have started outperforming large caps. For past one month, while, mid caps outperformed large caps at index level, ironically many midcap stocks have underperformed S&P BSE Sensex. Almost 40% constituents of CNX Midcap index have underperformed S&P BSE Sensex. Now the question is, will markets sustain the current rally and mid caps continue to outpace large caps?

Performance of mutual funds...
Although mid caps have started outperforming large caps, very select mid cap companies are doing well. This suggests that only those who were accurate in stock selection have benefited in the current market rally.

How Mutual Funds have performed?

	Returns (%)
	25-Sep-13 To 25-Oct-13	1 Year
Large cap oriented funds #	5.1	6.5
Mid and small cap oriented funds #	7.1	-0.8
Multi and flexicap oriented funds #	5.6	3.3
S&P BSE SENSEX	4.2	11.1
CNX Midcap	4.4	-5.5

Returns are expressed in absolute form
Note: Category average is considered
NAV Data as on October 25, 2013
(Ace MF, PersonalFN Resrach)  

As given in the table above, over the last one month period from September 25, 2013 to October 25, 2013 only the midcap oriented funds have clearly outperformed all other categories focusing on different market cap segments. But if we assess it from a 1 year perspective, they have clearly underperformed the other categories of funds as per market capitalisation. So, while, almost all midcap oriented funds managed to beat S&P BSE Sensex in the past 1 month, on 1-Year returns, all the funds are losers with some rare exceptions. But the performance of midcap oriented funds has been better than that of CNX Midcap Index on both timeframes. This shows that the stock selection of mid and small cap oriented funds have been fairly better.

As remains the question of large cap oriented funds, they too have fared better vis-à-vis the S&P BSE Sensex across the aforesaid time frame exhibited in the table above. About 86% and 74% of the large cap funds have outperformed S&P BSE Sensex on respective timeframes.

Performance of multi and flexi cap funds on the other hand, has been better than that of CNX Midcap index across aforesaid timeframes. While mid caps composition of portfolio held by multi and flexi cap funds has helped them to outperform large cap funds over last 1-month; their investment in large caps protected the downside over last 1 year. It is clear that mutual funds have put up a better show in the recent times. But now that markets have once again neared the earlier highs as seen in the year 2008 , it remains to be seen how mutual funds are positioning their portfolios.

Holding trends of mutual funds...
As per portfolios disclosed as on September 30, 2013; very few mutual funds are betting big on a particular midcap company. There have been 40 stocks in CNX Midcap (Out of 100) which occupied more than 5% in the portfolio of at least one fund. Moreover, there have been just 2 stocks which were given more than 5% of weightage in 10 or more funds. This suggests that, even midcap oriented funds have preferred to refrain from taking concentrated bets and have diversified across companies. In the midcap space, there are 31 such stocks in which more than 50 mutual funds invested. Out of those stocks only 18 stocks have managed to beat CNX Midcap while 21 have beaten S&P BSE Sensex. This hints at how tough the stock selection has been.

As far as sector selection goes, the market trend has remained similar by and large across market cap segments. Sectors such as banking which were out of flavour for considerable time, came back strongly. This trend was not only observed in large caps but also in mid caps. Two private sector banks remained the most preferred bets across mutual funds. As rupee fell, stocks from information and technology space shone. Midcap companies in consumer non-durable segments also did well for mutual funds.

As remains the question about taking a directional call; there is no consensus among mutual fund houses. While some fund houses are buying on dips others are raising cash component whenever markets rally. To avoid error of judgment; some houses have preferred to stay invested irrespective of market levels.

Outlook...
Upbeat global sentiment has been driving the markets up. However, growth prospects in India continue to remain weak. RBI has slashed GDP growth outlook to 4.8% from 5.7% for the current fiscal. Inflation has been advancing consistently. Retail inflation, driven largely by food inflation, is deterring RBI from adopting a softer stance towards growth. Burden of higher interest rates may result in tepid profit growth, which is evident in 2nd quarter numbers of India Inc. Although revenues of about 360 companies (which have declared quarterly number till date) have grown at around 15%, profit growth has been only 5%.

PersonalFN is of the view that scope for sustained rally from hereon is limited due to ordinary fundamentals and relatively expensive valuations. Holding trends of mutual funds also suggest that there is no bullish expectation at the moment. Rally in large caps as well as in mid caps has been stock specific and is restricted only to select sectors. Retail participation in the market is at multi-year low.

On this backdrop, PersonalFN recommends mutual fund investors not to invest in funds following bullish market momentum. On the contrary, PersonalFN believes investors would be better-off having funds which follow strong investment processes and systems. Moreover, it is imperative to stick to your personalised asset allocation and invest in mutual funds keeping long term financial objectives in mind. Investing only in midcap funds with expectation of higher returns may not work well for investors since performance of many midcap companies is under pressure. As seen above, multi and flexi cap funds have been better than midcap focused funds in managing downside risk enabled by their mandate. Their return potential also has been higher than those focused on large cap segment. PersonalFN believes selection of the fund plays a crucial role in your success as an investor.

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