After 2 years of underperformance, midcap and smallcap stocks are starting to regain their strength and beat the benchmark indices. In the last 1 year midcap and smallcap, stocks have outperformed benchmarks by at least 10 percent.

The exemplary performance of midcap and smallcap stocks have also been reflected in midcap and smallcap funds. Over the last 10 years, returns of the majority of midcap and smallcap funds have beaten their respective indices.

In 2020, when the markets crashed because of the COVID pandemic, an even steeper fall was reported in mid and small-cap funds. However, once the recovery started, these funds also rebounded quickly.

One must always keep in mind, the fluctuations in these funds may be higher than the market volatility. The fall steeper and recover faster. There is a higher level of risk associated with investing in these funds as compared to large-cap funds but the growth potential is also better.

Let's take a look at some key things one must keep in mind before investing in mid-cap and small-cap funds:

1) Performance is the key aspect of midcap and smallcap funds. Before investing in any such fund one must look at its performance at least for the last 5 years. Only if the fund has given stable and consistent returns in that period, you can consider investing in the fund. One must note that good past performance does not guarantee future returns, but it is a good indication of the quality of the fund and as close an assurance as possible. Unlike large-cap funds, mid and small-cap funds are more prone to market volatility and if these funds have given stable performance in the last 5 years despite the volatility, investment in such firms can be considered.

2) How much exposure do you have in midcap and smallcap funds is equally important. Not more than 25-30 percent of your entire portfolio should constitute these funds. There must be enough room for safer assets to provide you with a cushion in case of a steep decline.

3) Liquidity is another important aspect to consider. It is basically the amount of time any fund will take to meet near-term redemptions by investors. For most large-cap funds, this time is around 1-2 days however it increased in the case of midcap and smallcap funds. This is important to note in case you want to withdraw urgently due to massive volatility in the markets.

4) It is easy to have higher returns in your midcap and smallcap funds by adding high-risk stocks to the mix. But one must clearly understand the risk associated. It is pertinent to compare stocks between funds and be sure that the fund is not only giving better returns because of high-risk stocks. There are some basic financial ratios like the Sharpe ratio which can help you determine this.

5) One must always look for midcap and smallcap funds in fund houses that have been in business for a long time and have established their brand value.

6) You should always have a long-term investment in mind while investing in these funds - at least 5 years. This gives them time to recover in case of a market crash.

7) It is better to invest in SIP mode than a lump sum in these funds since the interest is compounded.

While investing in smallcap and midcap funds, it is important to understand the risk ahead. These provide great investment opportunities for everyone but it is important to limit exposure and diversify.