Mid- and small-cap mutual funds are in focus. According to Morningstar India, a mutual fund tracking entity, small- and mid-cap funds have delivered an average three-month return of 19.71%, a little higher than large-cap mutual funds' 14.86%. Sure, comparing the two categories is indeed erroneous because the categories behave totally differently at different point of time. Sometimes mid- and small-caps follow large-caps in a rally. Sometimes the opposite is true. However, what cannot be denied is that many experts believe that small- and mid-cap schemes can boost overall returns of a portfolio.
These funds have outperformed the large-cap funds because of the low base effect. That does not necessarily mean that small- and mid-cap funds can substitute the large-cap funds in your portfolio. Even as these funds are poised to offer promising returns this year, an investor should exercise extreme caution while buying these funds.

Should You Buy ?

The recent upswing in performance of mid- and small-cap funds is due to the extreme low valuations of mid- and small-cap companies in December 2011. The gap between the valuations enjoyed by large-cap indices and mid-cap indices has been reduced after this rally.

Valuations for large-cap stocks are slightly lower than their long-term average. This makes large-cap stocks more attractive when compared to mid- and small-cap stocks, purely from the valuations perspective. But there is always a case for investing in high growth, which is possible in mid and small-cap companies.

After the recent selling in the equity markets in March, the valuations are a bit more sane now. Considering the fact that there is nothing seriously wrong with macroeconomic data and other macro indicators, equity markets may look to be in the positive zone. Because the mid-cap stocks and funds have been undervalued, these funds may outperform the large-cap funds category in the near future. One should invest with a staggered approach and buy into these funds on dips or thought a systematic investment plan. This should help you avoid timing risk while investing for a long time frame – say three to five years.

How To Choose A Mid-Cap Fund ?

Unlike a large cap mutual fund, the performance of a small- and mid-cap fund is largely dependent on the stock picking capability of the fund manager.

A large cap fund may beat the index by x% and another large cap fund by y%, but nothing goes drastically wrong in this category. But a well informed fund manager is a pre-requisite for mid- and small-cap mutual funds. Also, you should do more homework before choosing the fund. Ideally you should check the fund manager's track record, read some of his views on investment strategy, investment philosophy, which sectors he/she is bullish on etc.

What Should The Existing Investors Do ?

If you already have an exposure to mid- and small-cap mutual funds, it is time to review your portfolio. Compare the performance of your mutual funds with the index and other small- and large-cap funds. Ideally, you should have invested in top quartile funds in this category. If you have not invested in the top quartile funds, now is the time to move your existing investments towards such funds.

Risk

A look at the yearly returns reveals that small- and mid-cap funds tend to outperform their large-cap peers in a rising market, for example, the bull market years of 2007 and 2009. However, in those years when the market fell or corrected significantly, small- and mid-cap funds tend to underperform. While making a decision, you should also look at volatility. The adjoining table makes it clear that mid-cap funds are more volatile than large-cap funds, as implied by their higher standard deviations over various time periods. So these funds are more suited to investors with slightly higher risk profile, who are able to digest losses and volatility.