Can there be a life without mid-caps stocks? After all, they can make you money fast, but they can also cause you huge losses.

Though answering this cynical question might appear difficult, we can probe the facts to find the answer.

If you go by the equity fund portfolios of various fund houses, most of them will be adorned by mid-cap stocks.

Such is the conviction of asset management companies (mutual funds that manage your money) that they have several dedicated funds that exclusively invest in mid-cap shares.

With the BSE Mid-cap index delivering an annualised returns of 34 per cent during the last three years as compared to Sensex's 31.87 per cent, mid-caps are clearly in the reckoning and no portfolio can be complete without them.

(The BSE Mid-cap index lists a representative number of mid-sized companies only and reflects the changes in the prices of their shares. The BSE Sensex has 30 stocks; the manner in which these stocks increase or decrease in value indicates how the stock market is performing).

The fund managers who invested with conviction in mid-cap companies have been rewarded well.

Though essentially diversified funds, the mid-cap funds are always on a look out for multi-baggers (companies whose stock prices grow by leaps and bounds over a period of time; for instance Infosys [Get Quote]), which have the potential of becoming large-cap companies.

However, a word of caution is in place here. Mid-caps, as fast as they rise, can also sink without a trace.

Why mid-caps?

Mid-cap companies are viewed as wealth creators as they have the potential of joining the large cap club. Mid-caps can adapt faster to changes and are nimble. But, for fund managers, the task of identifying such companies has always been a challenge. A fund is worth investing in if its manager is able to do this consistently.

• How to identify best mutual funds

However there are funds which, despite having a mid-cap orientation, like to play safe. Large companies like Reliance Industries [Get Quote], TCS [Get Quote], Infosys, Bharti, etc, adorn their portfolio, and more often than not, figure among their top holdings.

Additionally, some funds have extremely large numbers of stocks which reduces their risk element through large diversification. The case in point is Sundaram BNP Paribas Select Midcap. It is extremely diversified, with 100 plus stocks in its portfolio. Additionally, the fund also likes to keep a lot of cash (around 20 per cent) -- this helps them to buy more of the same stocks in case the stock market falls substantially. The fund has the reputation of identifying quite a few multi-baggers like Kalpataru Power and Laxmi Machine Works.

However it should be kept in mind that not every mid-cap is a success story. Anybody can burn hands if they are only taking selective bets on these funds. Some of them will not be equipped to survive the downfall and may sink without a trace.

Mid-caps stocks tend to combine the characteristics of large caps and small caps by offering more growth than the former but less risk than the latter. But, if a fund has invested in dominantly mid-cap stocks, then it may find it difficult to make a timely exit due to the liquidity constraints of such stocks (sometimes, even if the fund wants to sell a particular stock, there may not be any buyers for it).

But not all funds believe in this strategy. They like to take selective bets on a company. For example, Birla MNC's top three sectors constitutes around 46 per cent of its portfolio and the fund restricts itself to around 25-35 stocks. The fund which, till last year, had a large-cap orientation has now aggressively turned towards mid-cap stocks.

The flip side of mid-cap funds

So far so good. But have the funds been any good in protecting the downside?

Last year, when the markets had declined by a third (between May 11, 2006, and June 14, 2006), the BSE Mid-cap had lost 32 per cent and CNX Mid-cap (this is the mid-cap index on the National Stock Exchange) was also down by around 31 per cent. Though the mid-cap funds had started feeling the heat in May itself (when they began to lose at almost the same rate as diversified category's 12 per cent loss), the loss was more severe in June.

• Should you invest in a mid-cap fund? 

In June 2006, when the diversified equity category had lost 5.7 per cent, funds like Franklin India Prima, HDFC [Get Quote] Capital Builder, Tauras Star Share, DBS Chola Opportunities, Tata Growth, etc -- which are all mid-cap funds -- had lost between 9 and 11 per cent.

Year	BSE Sensex(Returns in per cent)	CNX Nifty (Returns in per cent)	CNX Mid-cap (Returns in per cent)	CNX Mid-cap 200 (Returns in per cent)	CNX Mid-cap(Returns in per cent)	BSE Small-cap (Returns in per cent)
2002	3.52	3.25	--	22.77	--	--
2003	72.89	71.90	--	135.97	--	--
2004	13.08	10.68	25.55	44.61	24.96	41.07
2005	42.33	36.34	46.63	41.07	35.04	73.18
2006	46.70	39.83	31.13	--	29.01	15.97
2007*	0.62	3.06	-0.16	--	0.88	1.47

*Since start of the year till April 30, 2007

However, in February this year, when the equity-diversified category fell by around 8 per cent, most such mid-cap funds fell less than the category.

Watch out for the swelling fund size

After you are convinced that you are willing to take a chance with the aggressive funds, one thing should be of concern -- the fund's swelling size.

• How equity funds help you make money

The top-performing funds are getting bigger and bigger. Reliance Growth is as big as Rs 3,556 crore. Considering that the fund that had only Rs 1,962 crore assets under management in July 2006, this rings a bell. Similarly the corpus of Sundaram Select Midcap had been growing steadily and it now manages assets worth Rs 2,163 crore.

With the mid-caps being relatively less liquid stocks (hence difficult to sell in large numbers when the need arises), huge holdings in them could adversely affect your exit options. Moreover if any particular stock surges and becomes a multi-bagger, then its impact on the overall fund performance will be limited. A small fund is also more agile and can enter and exit mid- and small- stocks at ease.

Mid-caps truly reflect the growth of the economy. They cannot be your core holding but you can't live without them either.