If you can stomach volatility and have a long-term horizon, you could consider the DSP Merrill Lynch's (DSPML) Small and Medium Term Fund. But why small and midcaps?

The fund believes these scrips are the best positioned to capture the growth in sunrise sectors. It cites the example of IT, auto components and pharmaceuticals as the three sectors that have grown at a scorching pace over the last decade.

In terms of returns, the fund house says that over the last five years the CNX Midcap has had higher growth rates (43 per cent) than the Nifty (26.5 per cent) and the Sensex (29 per cent) and that the number of companies with a net profit in the Rs 100-Rs 500 crore (Rs 1-5 billion) range has grown four times.

The fund defines midcaps as those that have a market capitalisation between Rs 1,800 crore (Rs 18 billion) and Rs 4,500 crore (Rs 45 billion).

The US index Russel Midcap too has outperformed the Dow over the last 14 years by giving a return of nearly 11.5 per cent compared to the Dow's 9. So, which are the stocks that have been small caps and have grown over a period of time to become large caps and their prices too have touched record highs.

A case in point is Wipro [Get Quote] where Rs 10,000 invested in March 1990 is worth Rs 92 lakh (Rs 9.2 million) in 2006. If net profit is taken into consideration, HDFC Bank's [Get Quote] bottomline grew from Rs 20 crore (Rs 200 million) in 1996 to Rs 871 crore (Rs 8.71 billion) in 2006, Hero Honda's PAT grew from Rs 26 crore (Rs 260 million) to Rs 971crore (Rs 9.71 billion) in the same period.

While this is true, stocks that are part of this segment have also experienced the biggest falls when the market moves in the other direction. The ability to generate consistent profits will depend on the quality of management and its ability to scale up quickly.

DSP Merrill has maintained a good performance track record so far. Over a five year period, its Equity, Opportunities and Technology.com funds have outperformed their benchmarks and category returns.

In this period, while the technology fund has given returns of 46 per cent, its Equity and Opportunities fund have returned 49 and 54 per cent respectively. According to the fund, the three ingredients that will help small and mid caps grow into large caps are scale, management quality and the holding period.

The fund justifies the launch of a small and medium cap now as it believes that India is in the midst of an expansion phase and is likely to register high growth rates.

On a market cap to GDP ratio parameter the fund says that at 148 per cent (1989) up from 37 per cent (1981) the 80s decade belonged to Japan, the 90s to the US which had a ratio of 163 per cent (2000) up from 71 per cent in 1991.

The Indian figure is at 91 per cent in 2006 up from 52 per cent in 2000. It believes that there is a scope to generate superior returns based on the higher growth trajectory of smaller companies and appreciation of the stocks that will come about due to a re-rating of under researched companies.

Further, the institutional holdings in these companies are low and the stock price of such companies tend to trade below their intrinsic value. While institutions hold 38 per cent and 26 per cent in Sensex and BSE Midcap  indices their holding in BSE Small Cap index is only 15 per cent.

Despite a flurry of new fund launches over the past couple of years, DSP Merrill has not launched a single fund during the period.

According to president and CEO of the fund S Naganath, the firm abstained from new launches because it was not comfortable with the idea of amortising initial issue expenses, which normally worked to the detriment of long term investors. Besides, the fund likes to focus on greater degree of product differentiation. Going by the track record of the fund manager, the fund is worth considering.

Fund Details: The minimum investment in this scheme is Rs 5,000. It comes with growth, dividend and SIP options. The entry load is 2.25 per cent while the exit load is 0.5 per cent. For Systematic Investment Plans, the entry load is 1 per cent.

Offer closes: October 16, 2006.