As a new investor, you may not have heard of equity funds, but learning about them should be at the start of your financial journey. Understand the basics of how they work and how to invest in them, and you will be more informed when you invest.
What Is an Equity Fund?
An equity fund is an open-end fund like a mutual fund or ETF, closed-end fund, or unit investment trust (UIT), that buys ownership in businesses (hence the term "equity"), most often in the form of publicly traded common stock.
You can contrast it with a bond fund or fixed-income fund, which is invested primarily in bonds.
- Alternate name: stock fund
Equity funds can be bought as both traditional mutual funds and as exchange-traded funds (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 financial goals and circumstances.
How an Equity Fund Works
An equity fund scheme boils down to investors giving money to a fund, which pools that money and invests it in stocks, enabling investors to reap the gains (or the losses).
The fund selects the stocks in the equity funds based on the fund's objective and investment style, which can vary widely.
For example, let's say that Fund A invests based on market capitalization and follows a growth investment style. It might invest in small-cap stocks, which tend to carry a greater potential for growth and volatility than large-cap stocks.
The common denominator with all equity funds, however, is capital appreciation, or an increase in the investment's value. In contrast, bond funds are designed to accrue income for the investor.
Types of Equity Funds
There are three major kinds of stock funds: those focused on market capitalization or geography or those following a particular investment style.
Equity Funds Focused on Market Capitalization
Market capitalization, or market cap, is an indication of a business's value based on share price and the number of outstanding shares. As such, these are stock funds that target companies of certain capitalization ranges, including:
- Mega-cap equity funds: These funds invest in stocks of companies with a market cap of $200 billion and greater, which are generally industry leaders. Think Microsoft.
- Large-cap equity funds: One tier below mega-cap funds are large-cap equity funds that invest in companies with a market cap of between $10 billion and $200 billion, such as General Electric.
- Mid-cap equity funds: These equity funds target companies with a market cap of $2 billion to $10 billion, like the footwear company Crocs.
- Small-cap equity funds: These invest in companies with a market cap of $300 million to $2 billion, such as the information technology firm Unisys Corporation.
- Micro-cap equity funds: These equity funds are invested in tiny publicly traded companies with a market cap of between $50 million and $300 million, such as Peoples Financial Services Corp.
Equity Funds Focused on Geography
These funds are invested in companies in one or more regions of the world, and include:
- Global or worldwide equity funds: These are invested in stocks around the world, including those in the United States. They tend to avoid making distinctions between domestic and international assets, following wherever the portfolio manager or investment methodology dictates. In fact, some of the funds hold as much as stock in U.S. firms as domestic equity funds.
- International equity funds: These overseas-only funds invest exclusively in stocks outside of the U.S.
- Country or regional equity funds: These domestic funds invest in stocks solely in the home country or region of the investor and issuer. A fund that invests in China would be an example of a country equity fund; one that invests throughout Asia would be a regional fund.
Equity Funds Focused on Investing Style
These are funds that use one of four major methodologies when selecting stocks: the top-down strategy, bottom-up strategy, growth strategy, or value strategy. Major examples of funds adopting each strategy include:
- Sector- or industry-specific equity funds: These funds often employ a top-down strategy where the best stocks in a particular industry or sector are included in the fund. This can be appealing for those who want to invest their money in certain types of businesses, which may not be a bad idea since certain industries have disproportionately produced high returns for owners.
- Equity income funds: These funds often employ a bottom-up strategy whereby they seek ownership of businesses that pay a significant dividend, often irrespective of the sector. These funds are designed to bring income to the investor rather than just capital growth.
- Growth funds: These funds employ the growth strategy, investing in stocks with a consistent track record of profitability and growth, and are expected to keep doing so, such as those in the technology sectors.
- Value funds: These funds adopt the value strategy whereby they seek to buy undervalued stocks that are expected to grow substantially in the future.
How to Invest in Equity Funds
Once you decide you want to invest in equity funds, check out the fund offerings at major providers before you buy.
Generally, you are looking for an equity fund that has:
- Low costs, as measured by the expense ratio and the lack of a sales load
- Little to no turnover in the underlying portfolio
- An investing strategy or philosophy that you agree with
- A broadly diversified portfolio
- Portfolio managers that invest a majority of their net worth in the same assets alongside you, putting their money where their mouth is
- A clearly defined mission so that you understand the types of assets it acquires, the reason it acquires them, and the reason it sells them
- A history of steady portfolio management
Also, browse online fund rankings. Once you've narrowed down your list of potential investments, read the mutual fund prospectus and statement of additional information (SAI). These documents explain how the mutual fund plans on investing your money and a host of other valuable information that can make reaching an informed decision easier. But you can also cement your decision with the help of a registered investment advisor.
When it's time to invest, 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 fund through a brokerage account.
- Buy shares of an equity 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 fund.
Stock mutual funds and ETFs distribute nearly all the dividend income they earn (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 in 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 is often as low as $1,000. You can often lower that minimum to $50 or potentially less by enrolling in automatic investments. There are also several ETFs that mimic equity mutual funds, but you can trade them from your own brokerage account, typically for low fees.
Equity Funds vs. Mutual Funds
Equity funds can take the form of an open-end fund like a mutual fund, a closed-end fund, or a UIT. However, they always invest primarily in stock.
A mutual fund collects money from many investors and invests it in stocks, bonds, or short-term debt. As such, a mutual fund can be a stock fund or a bond fund, whereas an equity fund will never primarily invest in bonds.
Similarly, equity funds have an overarching aim of capital appreciation, which may not be the case for all mutual funds. A bond fund, for example, seeks to provide income to the investor.
The performance of the average equity fund or mutual fund depends on the mix of underlying securities. But stocks have historically performed better over the long term than bonds, so an equity fund may do better over time than a mutual fund invested primarily in bonds.
|Equity Fund||Mutual Fund|
|Primarily invests in stocks||May invest in stocks, bonds, or debt securities|
|Seek capital appreciation||Objectives vary, and may seek to produce income|
|Underlying securities perform well over time||Underlying securities vary, but bonds perform worse over the long term|
- An equity fund is a special type of mutual fund or exchange-traded fund (ETF) that invests in common stocks, or equities, rather than bonds.
- Funds select stocks based on the fund objective and investment style.
- The main categories are those based on market capitalization, geography, and investment style.
- Individuals can invest directly with a mutual fund family, buy fund shares through a brokerage account or retirement plan. They seek low-cost equity funds that provide diversification.
- Equity funds can take the form of mutual funds, but the latter more broadly invests in stocks, bonds, or debt securities.