Here are some good-to-know facts about mid-cap equity funds before you invest

Owing to the coronavirus pandemic and the associated economic crisis, markets across the world have come off their highs. As markets go up again, investors are looking to invest, especially in mutual funds. One option which investors should consider is investing in mid-cap equity funds. Generally, mid-cap equity funds deliver high returns when the market goes up. Here are some good-to-know facts about mid-cap equity funds before you invest in these funds.

Higher risk reward ratio
Generally mid-cap funds invest in smaller and not very well-known companies which are in the growth trajectory. Such companies are not generally noticed by research analysts. But, once these companies grow in their size, revenue and profit they are recognised by the analysts / market and enjoy higher valuations. This category of funds aims to gain from the change in the valuations that happen when a mid-cap company grows into a large-cap company. Mid-sized firms have more scope to expand and often in their rapid growth phase. Thus, the risk reward ratio for investors in such funds is high.

Associated risk
Though mid-cap equity funds deliver exceptional profits, they carry significant market risk. Investors who have high risk appetite can invest in mid-cap equity funds. With a higher return, the investment also carries a high risk. Weigh their financial goals and risk appetite before making a decision. Invest in mid-cap equity funds if the market volatility does not affect you much and your investment horizon is longer.

Use capture ratio
Capture ratio highlights the performance of a mutual fund as compared to its benchmark. In order to use capture ratio to evaluate mutual fund performance, it is essential to know what is the upside and downside capture ratio. As the name indicates, upside ratio deals with performance of funds when the market or benchmark is bullish.

Downside ratio deals with performance of funds when the market or benchmark is bearish.

Basically, these ratios show whether a given fund has outperformed or gained more or lost less than a broad market benchmark during periods of market strength and weakness, and if so, by how much. An upside capture ratio over 100 indicates a fund has outperformed the benchmark during periods of positive returns for the benchmark. A downside capture ratio of less than 100 indicates that a fund has lost less than its benchmark in periods when the benchmark has been in the red.

How to choose mid-cap equity funds?
Different mid-cap schemes invest across different securities and sectors in order to optimise returns. The strategy followed by the fund house will have an impact on the portfolio. The returns vary according to the tenure and sector of investment.

In order to diversify the risk, it is ideal to invest across different sectors, thereby reducing sector-specific risk. If you choose to hold mid-cap equity in your portfolio, you need to ensure that the exposure to the same remains 25-30% in order to keep it productive.

To conclude, mid-cap equity funds are riskier than large-cap funds as they are comparatively more volatile in nature. Before investing in mid-cap equity funds, investors should review their financial goals, risk appetite and select the right mutual fund.

The writer is a professor of finance & accounting, IIM Tiruchirappalli