What Is an Equity Fund?
An Introduction to Equity Funds for Mutual Fund Investors
"What is an equity fund?" is a common question asked by many new investors. Though the answer might be simple, it is merely the starting line on your journey to financial independence. Once you understand what equity funds are, you still have to sort through the thousands of available options to find the best fit for your family's portfolio. First let's clear up the word 'equity' - for our purposes, it simply is another word for stocks. So an equity fund is one which invests in stocks.
My hope is to walk you through some of the basics so you'll be more informed about what you're seeing whenever you look at a mutual fund prospectus or are speaking with a registered investment advisor.
The Definition: What Is an Equity Fund?
An equity fund is a type of mutual fund or private investment fund, such as a hedge fund, that buys ownership in businesses (hence the term "equity") most often in the form of publicly traded common stock.
The common denominator with an equity fund is the desire for fund management to find good opportunities to invest in businesses that will grow, throwing off ever-increasing gushers of profit for the owners, as opposed to a bond fund or fixed income fund, which uses shareholder money to make loans to companies or governments, collecting interest income.
What Are the Different Types of Equity Funds?
To go one step further than answering "What is an equity fund?", we need to look at the different types of equity funds currently available to investors. For sake of clarity, let's break equity funds down into a handful of the categories you are most likely to encounter.
Equity Funds Focused on Geography
- International Equity Funds are those that invest in stocks outside of the United States.
- Global Equity Funds are those that invest in stocks around the world including those in the United States but tend to favor foreign stocks by at least 80% of their overall portfolio weighting.
- Worldwide Equity Funds are those that invest in stocks around the world with no distinction between domestic or international assets, following wherever the portfolio managers or methodology dictate.
- Domestic Equity Funds are those that invest in stocks solely in the home country of the investor and issuer. For most readers, this will be the United States.
Equity Funds Focused on Market Capitalization
- Mega Cap Equity Funds are those that invest in stocks of the biggest companies in the world; behemoths worth hundreds of billions of dollars like Walmart or Berkshire Hathaway.
- Large Cap Equity Funds are those that invest in companies with a large market capitalization.
- Mid Cap Equity Funds are those that invest in companies with a medium market capitalization.
- Small Cap Equity Funds are those that invest in companies with a small market capitalization.
- Micro Cap Equity Funds are those that invest in tiny publicly traded companies worth a few million, or few tens of millions of dollars, in market capitalization.
Equity Funds Focused on Investing Style
- Private Equity Funds are those that invest in privately held companies that don't trade on the stock market. They may set up a limited liability company, infuse millions, or even billions, of dollars into it, raise money by issuing bonds, and then acquire businesses management believes it can improve.
- Equity Income Funds are those that invest in ownership of businesses that pay a significant dividend, often measured by a history of dividend increases, absolute and relative dividend yield, and conservative dividend coverage ratios. These finds are designed to bring income to the investor rather than just capital growth.
- Dividend Growth Funds are those that invest in ownership of businesses with a record of increasing dividends per share at a much faster rate than the stock market as a whole. There are many different ways to make money with a dividend growth strategy, they sometimes beat their higher-yielding counterparts, and, in many cases, can make wonderful buy-and-hold investments. Equity income and dividend growth funds are similar.
- Index Equity Funds are those that mimic an index such as the Dow Jones Industrial Average or the S&P 500. Though not always true, index equity funds tend to have some of the lowest mutual fund expense ratios. Investors have been flocking to index funds in recent years due to these low costs and simplicity. They are often "passively managed" meaning that there is no fund manager working to "beat the market." Funds that do pick stocks or time the market are active funds.
- Sector or Industry Specific Equity Funds are those that track specific areas of the economy, such as industries or sectors. This can be appealing for those who want to invest their money in certain types of businesses, which may not be a bad idea given that certain industries have disproportionately produced high returns for owners.
- Value Funds are those that seek to buy undervalued stocks as deemed by fundamental analysis that looks at things like book value relative to share price and dividend yield.
- Growth Funds are those that invest in stocks with high growth potential, such as those in the technology or bio-pharmaceutical sectors. These companies may have unfavorable fundamentals, but the hope is that the companies will grow into their figures and produce a higher than average rate of return for investors.
In addition, equity funds can be bought as both traditional mutual funds and as exchange-traded funds, or ETFs. Some investors tend to favor one type over the other but there are advantages and disadvantages to both depending on how the mutual fund is structured and the investor's goals and situation.
Different Ways You Can Invest in Equity Funds
When you decide that investing in an equity fund is the route you want to take for your portfolio, you have several options that might make sense. You can:
- Open an account directly with a mutual fund family such as Vanguard or Fidelity.
- Buy shares of an equity mutual fund through a brokerage account.
- Buy shares of an equity mutual fund through your 401(k) or 403(b) plan at work.
- Open a Roth IRA or Traditional IRA at a brokerage firm and use it to buy shares of an equity mutual fund.
Just as with regular mutual funds, publicly traded equity funds are required to distribute all dividend income and realized capital gains (if any) to shareholders each year. As a result, you have to look at your total return, not just the share price, which can be deceiving depending on the level of distributions made in any given time period. Most brokerage firms and virtually all mutual fund companies will allow you to automatically reinvest any distributions, in whole or part, into more shares of the fund so you increase your total ownership over time.
The minimum investment amount to begin acquiring these funds varies, but in most cases (especially for retirement accounts), they can be as low as $5 with regular monthly withdrawals from your savings account or checking account of $50 or more to help you build your investment portfolio over time. If bought through a plain vanilla brokerage account, the minimum can be $1,000, $2,500, $5,000, $10,000 or $25,000. Institutional equity funds can have minimum investments of $1 million or even $10 million.
There are also several exchange traded funds, or ETFs, that mimic equity mutual funds but which you can trade from your own brokerage account, typically for very low fees.