If you invested in mid-cap funds a couple of months back, you would have already made a neat packet. Those who did not are actively considering making an investment now.

Your investment advisor/bank have probably been showing you a lot of numbers on why you should invest in these funds. They may be right. But do you know what you are getting into?

What are mid-cap funds?

These are mutual fund schemes which invest in small/medium sized companies. There is no standard definition for classifying companies as small or medium. Generally companies with a market capitalisation or market value (no. of shares * market price of a share) of up to Rs 500 crore (Rs 5 billion) are classified as small.

Those companies that have a market capitalisation between Rs 500 crore and Rs 1,000 crore (Rs 10 billion) are classified as medium sized.

Benefits of investing in small/mid-sized companies

• Small/mid sized companies tend to be under researched thus giving you an opportunity to invest in a company that is yet to be identified by the market i.e. while you may have 200 analysts covering Hindustan Lever, you will probably have few (or maybe none) covering stocks like Matrix Laboratories (in year 2000). So if you spot an opportunity you can purchase shares in the company at relatively attractive valuations.

• Such companies offer higher growth potential going forward and therefore an opportunity to benefit from higher than average valuations.

Risks involved in investing in small/mid-sized companies

Since such companies are under researched there is a greater chance that you may miss factoring in some 'reasons not to buy'. And even after investing in such companies, regular information is hard to come by.

• The chance of manipulation or fraud in such companies is higher as risk control measures tend to be neglected or not up to the mark (not that the larger peers are free from it!).

• Finally, shares of such companies tend to be illiquid and therefore in case the fund manager needs to sell the stock, he may either not be able to do so, or he would be able to do so only after a significant erosion in price.

Our view on mid-cap funds

Obviously the mid-cap rally has excited the retail investor enough to wonder if there is something in it for him as well.

The good news is that an equity investment based on sound fundamentals (or a sound investment approach in the case of mid-cap fund) bought with a long-term investment time-frame (at least 3-5 years) stands a good chance of delivering value to the investor.

Having said that, we would like to add some prerequisites to qualify the above observation. Investors with some appetite for risk must undoubtedly consider adding mid-cap funds to their existing mutual fund portfolio.

'Existing' is the operative word over here. It means that investors must have a portfolio to begin with, preferably with large cap diversified equity funds forming a substantial chunk.

It is all very well to invest in mid-cap funds, but they should not be your frontline mutual fund investment and they should not have a disproportionately high weightage in your portfolio.

Your 'bread and butter' funds so to speak, should be the large cap diversified equity funds, with mid-cap funds at the next rung.

Mid-cap funds are a good means to diversify your portfolio and add a flavour of growth when large cap funds are flagging. To seek a larger role for mid-cap funds than this may prove costly given the risks associated.

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• Have mid-cap funds outperformed their large cap peers over 1-year?