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Can diversified equity funds tilt heavily towards mid-caps?

What does diversification mean for a diversified equity fund? Does it mean it will diversify across sectors and scrips or does it mean it will diversify across market capitalisation stocks?

Outlook Money looked at equity funds to check out how little scheme objectives can tell you about their potential action. To keep things simple, we checked out only diversified equity funds. We omitted thematic, sectoral, dividend yield funds. We also left out closed-end funds and equity-linked savings schemes since they usually have a higher allocation towards mid-cap scrips on account of a lock-in. Then, we examined the portfolios of short-listed funds across five time periods since July 2005 when mid-cap scrips were the flavour of the market .

MF schemes that call themselves ‘diversified’ had an unusually high proportion of their assets in mid-cap scrips. In all of them (top five mid-cap exposure schemes), the average mid-cap exposure was 61 per cent.

Gunning for the flavour
As diversified equity funds have a mandate to go anywhere, some of them usually skew their portfolios towards scrips and sectors that are the flavour of the month. For instance, during the technology sector boom in 2000, many diversified equity funds had invested significant portions of their portfolios in technology sector scrips. Birla Advantage Fund had invested an average of 75 per cent of its portfolio in technology sector scrips between January and August 2000.

Unlike the 1999-2000 bull-run where only technology and related sectors were the flavour, the current run-up in equity markets has been more broad-based and encompassed several sectors. Additionally, small and medium-sized companies have revamped their operations, downsized and turned into profitable ventures. Since these companies have shown tremendous potential, they attracted foreign and local investors such as mutual funds that saw their share prices zoom. Since January 1, 2004, CNX Midcap index has returned 30 per cent on a compounded annualised basis, as against 28 per cent by the large-cap Nifty index. Returns between these two indices would not be comparable around a decade ago; now both are mentioned in the same breadth.

During the same time, 17 mid-cap funds were launched as compared to just five that were present prior. Additionally, diversified equity funds titled their portfolios towards mid-cap scrips to cash in on the boom.

Evolving markets and industry…
Things were different in earlier days when diversified equity funds were launched mainly as large-cap oriented funds, though they didn’t say so explicitly in their offer documents. Reason being, mid-cap scrips gained prominence only in the past four years when many of them restructured themselves. Years back, such companies were avoided by MFs as many of them were not highly profitable and suffered from low liquidity.

Only in the past four years, such companies have grown in stature and size, thanks also to a growing economy and acceptance of ‘Made-In-India’ products. Companies like Hero-Honda, Infosys, Bharti Airtel, etc. that were once mid-caps are today names to reckon with and are considered as large-cap, bluechip companies.

The investment universe for MFs has just gotten bigger. As regards to a modest size of companies available at the hands of your fund manager, say 10 years ago, today companies across market capitalisation, including established mid-caps, command as much attention from equity funds, as large-cap companies. Add to that to their growth potential – mid and small-cap scrips are generally not targeted by analysts and MFs in their initial years, but when discovered tend to register bigger gains than established companies – and it’s no wonder that even diversified equity funds want a pie of them, in addition to mid-cap funds.

…but stagnant definitions
Unfortunately, your diversified equity fund therefore still keeps harping on diversification that largely revolves around the number of scrips and sectors, but keeps mum on market capitalisation in its offer document. Technically, your fund is still said to be diversified even if it invests around 60-80 per cent of its corpus in mid-cap scrips, so long as it is has a sizeable number of scrips and sectors.

So are MFs wrong?
Theoretically, they are not. MFs are bound by their offer documents and can stretch their horizon as much as their offer documents allow them to. Most diversified equity funds phrase their objective in such a way that makes them mandatory to diversify across sectors and scrips, but rarely talks about market capitalisation of potential investments.

Most MFs don’t think that to be a problem. “Sebi mandates MFs to abide by their offer documents and treat them as the Bible. So as long as the offer document gives the leeway to the scheme, irrespective of whether the objective is loosely or tightly defined, it’s okay for schemes to skew their portfolios towards mid-caps”, says T. P. Raman, managing director, Sundaram BNP Paribas MF. Adds Krishnamurthy Vijayan, CEO, JP Morgan MF: “If a diversified equity fund goes heavy into mid-caps, you can’t fault him. In spirit though, it will not be advisable.” Industry sources say that if a fund manager has expertise in picking up stocks from a particular domain, his trustees may give him a larger leeway to play around in that domain, across all his funds, in one way or another.

Silent regulation
Sebi guidelines say that MFs must invest at least 65 per cent of its corpus in assets in tune with its objectives. This means an equity fund and a debt fund must invest at least 65 per cent of its assets in equities and debt, respectively. It is silent on other aspects in diversification. Internationally too, the US MF regulator Securities and Exchange Commission also doesn’t specify the market cap limit that diversified equity funds must work within. Further, says Sanjay Prakash, CEO HSBC MF: “One fund manager’s large-cap can be another manager’s mid-cap.” Prakash, though, feels that a standardised and flexible definition of various market caps would do well.

What should you do?
There isn’t a simple answer to this. As far as mid-cap funds are concerned, it’s easier look into the offer document as to what construes mid-cap scrips according to the fund. Or, say, a large-cap fund that explicitly says so, like Franklin India Bluechip and SBI Bluechip Funds. Or even some flexi-cap, multi-cap or ‘opportunity’ funds that at least claim in their offer documents to be go-anywhere schemes.

But if it’s a diversified equity fund, there’s little assurance that your fund manager would keep largely to large-caps and not sway into mid and small caps, especially in rising markets. It’s only when equity markets turn exceedingly volatile or start a downward trend that diversified equity funds titled heavily towards mid-caps would suffer. Stick with MFs that come with a long-term track record and watch out for consistent performance.


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