Mid-cap funds are the haute couture of the mutual fund industry. And, not without reason.

If you are still in awe of the Sensex's rise over the past few years, you have completely overlooked the pulse of the market - the spectacular rise of mid-caps.

With the BSE midcap index giving an annualised return of 39.41 per cent in the past three years, the Sensex returns of 34.15 per cent pale in comparison.

Mid-caps finally have their place in the sun with virtually every mutual fund house having a dedicated fund in its stable.

What makes them hot?

Before we get to that, we have to first come to terms with what makes a mid-cap stock. Na�vely put, as you probably have guessed, it is smaller than a large cap and larger than a small cap. To get some clarity, let's define the boundaries, which incidentally are left to each fund manager.

An absolute definition would be one that is based on a fixed-capitalisation level. For instance, Birla Midcap defines a mid-cap as a stock with a market capitalisation between Rs 150 crore (Rs 1.5 billion) and Rs 1,500 crore (Rs 15 billion).

Sundaram Select Midcap goes for a more relative approach. Mid-cap stocks are those with a market capitalisation less than that of the lowest capitalisation company on the S&P CNX Nifty or the highest capitalization company on the S&P CNX Nifty Junior (whichever is higher) and greater than that of the smallest share on the S&P CNX Nifty Junior.

At Value Research, we opt for a more relative definition. We classify large caps as the smallest number of stocks that can together equal 70 per cent of the total market capitalisation of the BSE.

Mid-caps are the smallest number of stocks that can equal the next 20 per cent of market capitalisation and small caps are the remaining companies that will add up to almost 10 per cent of the market's total value.

It is undeniable that the interest in mid-caps has been fuelled owing to sound fundamentals and strong earnings growth potential.

Smaller companies offer more potential for growth and have a long way to go before they become too large to sustain that growth level. They tend to be more nimble and react faster to changes.

This is the where you can scout for multi-baggers and get to invest in the future large-caps. But that is just one side of the picture. And too often, that is the only aspect considered by investors.

Despite the glamorous returns, mid-caps are a risky investment. While everyone tends to harp upon the fact that at one time Infosys and Bharti Airtel (earlier known as Bharti Televentures) were mid-caps, they are mum on the fact that there are a lot of mid-caps that will not grow into large-caps. Some will not be equipped to survive a bad phase since they have insufficient financial resources. Some will do better than the rest.

Mid-caps tend to combine the characteristics of large-caps and small-caps by offering more growth than the former and less risk than the latter. They score over small-caps by being more established, financially more resilient and more liquid.

But on all these issues, they score below large caps. Being characterised by lower market capitalisation and limited liquidity, when such a stock witness huge inflows, their prices zoom to astronomical levels irrespective of the fundamentals or whether there is a growth story in place. Picking up this trend, na�ve investors pump money into it and sooner or later end up losing money.

The lack of liquidity will also mean that it is difficult to buy or sell large blocks of shares without seriously affecting the price. If a fund manager takes a very high exposure to mid-caps, he will find it difficult to sell the holdings later given the liquidity constraints.

Historically, mid-caps have displayed the tendency to rise more than large-caps in a booming stock market and plunge to greater depths when the market dips. The current bull-run got many convinced that the easiest way to make money in the stock market was to invest in small stocks.

The smaller the stock, the higher the return, they believed. The stock market collapse in May also indicated that the smaller the stock, the greater the fall and the longer it took to recover. From the peak of May 10 to June 14, 2006, when the market bottomed out, the Sensex lost 29 per cent but the BSE Mid Cap lost 38.32 per cent while BSE Small Cap, 42 per cent.

Among diversified equity funds, the higher the investment in smaller stocks, the more severe the impact on their returns. The funds that were ranked among the top 25 per cent during May 10 to June 14, 2006, had an average 66 per cent invested in large-cap stocks, and less than 10 per cent in small-caps.

Scouting for jewels

Even if you are still willing to take a chance with mid-caps, choosing the right pick is no easy task. The universe of mid-cap stocks is larger than large-cap players, while the quantity and quality of information available on them is much less. Being rather illiquid, the maximum benefit will accrue to the earliest entrant.

So the challenge lies in picking up a winner before anyone else does. It would also require patience as it may take a while for the market to discover the stock and lead to a rise in its price. Given the above restraints, your best option would be to look for a quality mid-cap fund.

A primary concern among the top-performing mid-cap funds is their huge size. Reliance Growth is in a touching distance of Rs 2,000 crore (Rs 20 billion), while Franklin India Prima boasts of assets exceeding Rs 1,800 crore (Rs 18 billion).

The relatively younger but well established Sundaram BNP Select Midcap has also crossed the Rs 1,800-crore mark. Why does the size of the fund matter? With mid-caps being illiquid stocks, huge holdings in them could severely hamper price and exit options. A small fund is more agile and can enter and exit mid- and small-cap stocks according to changes in the market conditions but a big fund will not have this much of flexibility.

Your cup of tea?

Mid-caps truly reflect the stock market story - the growth of companies - which in turn reflects the growth of the economy. That is why mid-cap investing allows you to participate in the evolution of corporate India. The best way you can ride this wave is by buying and patiently holding on to it for years.

If patience is a virtue you boast of and you are not averse to some amount of risk, you should consider a mid-cap fund.

It should not be a core holding but can add the zing to your overall portfolio. But before you make your pick, take a good look at your current funds. Check if they have a heavy tilt towards mid-caps. If that is the case, then you need not consider an additional mid-cap holding.