India's diversified equity mutual funds rose in 2013 but underperformed the broader markets for the first time in five years, as returns were dampened by the losses in the mid- and small-cap shares as well as financial companies.
These funds gained 4.8 percent on average in 2013, according to data from fund tracker Lipper, delivering lesser annual returns than the benchmark BSE Sensex after 2008.
The Sensex touched life highs in 2013 and ended 9 percent higher, boosted by foreign inflows of more than $20 billion.
Shares of smaller companies, however, underperformed, with the BSE mid-cap index falling 5.7 percent and the small-cap index sliding 11.2 percent. Waqar Naqvi, chief executive at Taurus Mutual Fund, said the sharp fall in mid- and small-cap stocks came as a surprise in 2013.
"It was not expected that the market would create a life-time high again this year (2013) … I think it was a directional call which was unexpectedly in the other direction, which led to a situation where you did not load up yourself much more with large caps," Naqvi said.
Funds were hurt because of significant exposure to smaller shares - data from Morningstar India showed that 35.54 percent of equity funds' assets on average were allocated to such stocks during Jan-Nov. Data for December was not yet available.
Allocation to certain sectors also weighed on the performance of equity diversified funds in 2013. Financial services, which was fund managers' favourite sectoral bet throughout the year with an average allocation of 23.7 percent, affected unit values as the BSE banking index fell 9.3 percent.
Banking shares such as State Bank of India, the country's top lender, lost 26 percent while Punjab National Bank lost 28 percent in the year as the sector struggled after the central bank raised policy rates to rein in inflation and hiked short-term interest rates to support the rupee during the year.
The bad loans situation also worsened with India's economy registering its slowest pace of growth in a decade. Total bad loans at the end of June stood at nearly 2 trillion rupees, five times higher as compared to June 2008, and the central bank in December proposed new rules to help banks recover bad debts.
Among funds that bet solely on shares of financial services companies, the Kotak PSU Bank ETF and the Goldman Sachs PSU Bank ETF lost more than 28 percent in the year.
However, IT stocks emerged as star performers of 2013, benefiting from a depreciating rupee and an improving demand for services from developed economies such as the United States and Europe.
The BSE IT index jumped 60 percent in 2013, with stocks such as Tata Consultancy Services, India's No. 1 IT services firm, gaining 72 percent and Wipro rising 61 percent. IT stocks accounted for 13 percent of diversified funds' assets in 2013, data showed.
"Post the recent run-up in IT stocks, most of the IT companies are trading at fair valuations from one-year perspective. From long-term perspective, they are still attractive," said Ambareesh Baliga, managing partner at Edelweiss Global Wealth Management.
SBI Magnum Sector Funds Umbrella IT Fund emerged as India's best equity fund with returns of 83.37 percent, followed by the ICICI Prudential Technology fund that gained 62.5 percent, Lipper data showed.
Among other schemes, funds investing in government securities gained 4.84 percent on average while gold exchange-traded funds lost around 13 percent on falling gold prices in 2013.