India stock funds fail to capitalise on Jan rally; outlook muted

* Indian stock funds underperform broader markets in Jan

* Financials, small & midcap stocks weigh on funds

* IT funds shine as corporate earnings boost sector

By Aditya Kalra

NEW DELHI, Feb 4 (Reuters) - India's diversified stock mutual funds underperformed the broader market by a wide margin in January, as exposure to financials and to mid- and small-cap stocks hit returns, according to data compiled by fund tracker Lipper.

Funds overall returned 0.45 percent during a month in which India's 30-share BSE index rose 2.4 percent, up for a third consecutive month on the back of continued strong foreign net inflows and government reform measures such as allowing diesel prices to rise.

Muted gains in financials particularly weighed on funds. Fund managers had bet big on financials leading up to the Reserve Bank of India policy review on Jan. 29, but a cautious stance on further monetary easing surprised investors even as the central bank cut interest rates.

Investment managers are more cautious this month, ahead of India's 2013/14 federal budget to be unveiled on Feb. 28. The government is under pressure to rein in spending and subsidies to meet its fiscal deficit targets and avoid a ratings downgrade.

"It's a very difficult call for the fund managers," said R.K. Gupta, managing director at Taurus Mutual Fund.

"If the subsidy burdens, budgetary deficit rise, FII selling cannot be ruled out," he added referring to foreign institutional investors.

(For a table of mutual fund returns, click )

The BSE's banking sub-index rose 1.6 percent in January, dampening the overall performance of funds as the exposure to financials had reached 26.5 percent of total assets held by diversified stock funds as of the end of December, according to separate data from Morningstar India.

Meanwhile, mid- and small-cap stocks lagged peers in January, hurting performance, given these stocks collectively accounted for nearly 38 percent of assets as of end December according to the Morningstar data.

The BSE mid-cap index fell 2 percent, while the small-cap index fell 4.14 percent in the month.

Funds focused on the information technology (IT) sector emerged as the best performers in January, gaining 10 percent on an average, as corporate earnings from Infosys Ltd and Tata Consultancy Services Ltd boosted the sector. (Reporting by Aditya Kalra; Editing by Jeremy Laurence)