Mid-Cap Mutual Funds Face Challenges in Outperforming Benchmark

Mumbai: Mid-cap mutual fund schemes, once among the most popular investment categories, have struggled to keep pace with their benchmarks over the past three years. Of the 25 mid-cap mutual fund schemes in the market, only five have managed to outperform the Nifty 150 Midcap index. This underperformance can be attributed to the challenges fund managers face in deploying continuous inflows and an increased tendency to invest in blue-chip stocks, all while valuations of mid-cap stocks remain elevated.

Data from Value Research highlights that actively managed mid-cap funds delivered an average return of 25.36% over three years, compared to the Nifty 150 Midcap index’s return of 27.08% during the same period. This slight but significant difference underscores the difficulties faced by active managers in navigating the current mid-cap market environment.

Market Efficiency and Reduced Opportunities for Active Managers

A major factor contributing to this underperformance is the increased market efficiency within the mid-cap segment. As large amounts of money flow into mid-cap stocks, opportunities for active managers to find undervalued or mispriced stocks have diminished. “With high inflows into mid-cap stocks over the last few years, market efficiency within mid-caps has improved significantly. This leaves less room for active managers to identify mispriced stocks and generate alpha,” explains Kunal Valia, founder of Statlane, an investment advisory firm.

Over the last 12 months, mid-cap funds saw net inflows of ₹24,440 crore, while small-cap funds received ₹34,386 crore, and large-cap funds saw inflows of ₹7,287 crore. This sustained interest in mid-cap funds suggests strong investor confidence, but the increased capital has also contributed to the challenges faced by fund managers.

Fund Allocation Rules and Investment Challenges

Mid-cap funds are required to maintain at least 65% of their portfolio in stocks ranked 101-250 by market capitalization. The remaining 35% is left to the discretion of the fund manager, offering some flexibility but also imposing limitations on their ability to maneuver within a rapidly evolving market.

Fund managers have had to adjust their strategies amid these constraints. Some managers have reduced exposure to certain overheated mid-cap stocks that have continued to rise and avoided companies perceived to be of poor quality, further impacting fund performance. “Limitations in terms of the ability to take exposure to some of the low-quality stocks in the mid-cap index, alongside the need to manage large inflows during bull markets, have led to the underperformance of active mid-cap funds,” notes Vidya Bala, founding partner of Primeinvestor.in.

High Valuations and Investor Caution

A notable concern for many investors is the elevated valuation of mid-cap stocks. The Nifty Midcap 150 index currently trades at a Price-to-Earnings (PE) ratio of 44.2, significantly higher than its five-year average of 28.32. Despite these high valuations, the index has demonstrated impressive gains, rising by 27% in 2024 alone, 50.21% over the past year, and 105% over the past three years. In contrast, the Nifty index has grown by 15.22%, 30.74%, and 47.97% over the same periods, respectively.

These elevated valuations have prompted many fund managers to exercise caution. Given the increased scrutiny and the need to carefully balance their portfolios, many managers have opted to limit their exposure to stocks they perceive to be overvalued or at risk of a price correction.

Managing Inflows Amid a Bull Market

The continuous flow of money into equity mutual fund schemes, including mid-cap funds, has contributed to the overall strength of the market, despite concerns over high valuations in the smaller company segment. However, this influx of funds presents challenges for fund managers who must deploy capital effectively without overpaying for assets or exposing their portfolios to excessive risk.

This balancing act is particularly difficult in bull markets, where valuations tend to be stretched, and opportunities for buying undervalued assets are limited. As a result, some managers have shifted their focus towards quality stocks and blue chips, which are considered safer but may offer lower growth potential than riskier mid-caps.

The Road Ahead for Mid-Cap Funds

Looking forward, the performance of mid-cap mutual funds will likely depend on several factors, including market conditions, interest rates, and investor sentiment. While mid-caps have traditionally offered higher growth potential compared to large-cap stocks, the current market environment poses unique challenges for fund managers seeking to generate alpha.

Fund managers will need to remain vigilant and flexible, adjusting their strategies to navigate an increasingly efficient and competitive mid-cap market. As valuations remain high, there may be limited opportunities for active managers to outperform their benchmarks. However, those who can successfully identify undervalued assets and manage inflows effectively may still be able to deliver superior returns to their investors.

In summary, while mid-cap mutual funds continue to attract significant investor interest, their ability to outperform benchmarks has been hampered by market conditions, valuation challenges, and the need to manage large inflows carefully. Investors should remain aware of these dynamics when considering their mid-cap fund investments and continue to monitor fund performance closely.