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Updated on Friday, February 15, 2019
Ever feel like a huge part of the investing learning curve is mastering the terminology? Between a dizzying array of acronyms, range of investment types, and brokerage marketing copy, it can be tough to figure out the one question you likely have: How will this investment potentially affect my money?
Equity funds are one such investment type that can be confusing for a beginning investor. Below, learn what an equity fund is, how it works, and what to consider before including equity funds in your investment portfolio.
What is an equity fund?
An equity fund, also known as a stock fund, invests primarily in equities (aka stocks) rather than bonds or other assets. Through an equity fund, you own shares or fractions of shares of stocks in an array of companies.
The term encompasses a broad category of funds and, chances are if you have a 401(k), you may already be investing in equity funds. According to 2015 data from the Investment Company Institute, on average, 401(k) investors in their twenties had 28% of their 401(k) assets invested in equity funds.
Equity funds often focus on a specific theme. Some funds may focus on investing in technology companies, while others may invest in stocks of companies within a particular market index.
While you can choose which equity fund to invest in, you can’t pick and choose which publicly traded companies the fund invests in. Like all investments, these funds carry risk. But equity funds attempt to minimize these risks through portfolio diversification.
What kind of equity funds are there?
There are many types of equity funds and brokerages offer a range of options. There is no “right” equity fund to invest in, and which one you choose depends on your growth goals, your timeline, the distribution of your other investment dollars, and even your interests. Here are some equity funds and terms to consider.
Index funds track the performance of a set group of companies within a major market index. For example, an index fund that tracks the S&P 500 provides the investor exposure to the 500 publicly traded companies within the S&P 500 list and will broadly follow the movement of the market.
These index funds are divided into sizes — you may have seen the terms large-cap, mid-cap, small-cap. “Cap” refers to the market capitalization of a company. Large-cap funds, like the S&P 500, are filled with large, publicly traded companies with names you likely see and use in everyday life, including Amazon and McDonald’s. Meanwhile, small-cap funds have smaller market capitalization and newer companies. In general, the thinking goes that the smaller the cap, the riskier the investment — and the greater chance for reward.
International and global funds
These funds specialize in international investments. International investments can diversify a portfolio as well as give an investor exposure to emerging markets and international growth. These funds may be based on region, an index fund based on global markets, or may be focused on emerging markets.
Sector and specialty funds
These funds are based on broad categories of publicly traded companies, such as healthcare, real estate or information technology. Choosing a specialty fund can diversify your overall financial strategy. Some sector funds may perform well despite dips in the market — for example, utilities and healthcare are still necessities in a recession. But because sector funds don’t necessarily follow market predictions, these funds are sometimes seen as riskier than other equity fund options.
No matter what type of equity fund you choose, it’s important to know how your account is managed. There are two options: Actively managed funds or passively managed funds. Actively managed funds are funds that use research, trading and portfolio management to strategize based on the movement of the market. Passive management rides the market through highs and lows to hit a benchmark.
Which strategy is better? That depends. Morningstar data from 2017 found that 43% of active managers outperformed their passive peer — a feat that only 26% of active managers achieved in 2016. Also, actively managed funds often have higher fees than those that are passively managed.
Still, many investors may use a combination of both strategies, potentially choosing active management for sector and specialty funds, where research, modeling and industry knowledge could potentially be useful in creating and maintaining a high-performing portfolio.
What are the pros and cons of investing in equity funds?
Beginning investors who wish to potentially invest outside their 401(k) may wonder whether they should buy equity funds, individual stocks or consider another investment vehicle for their money, such as buying real estate. As with all investing decisions, the right answer depends on your unique goals, financial situation and tolerance for risk. Here are some things to consider when considering investing in equity funds.
Pros of investing in equity funds
- A relatively low-maintenance way to manage investments. Instead of researching each company before purchasing stock, an investor can research the performance of the fund and periodically check in on its performance.
- Risk mitigation through a range of investments. One potential advantage of investing in an equity fund is that it offers exposure to many publicly traded companies at once, which can help mitigate risk when one particular company underperforms.
- Potentially lower fees than purchasing individual stocks. Buying individual stocks can come with fees, commissions and asset charges. While equity funds have management fees, fees for investment funds have dropped dramatically across the board since the 2008 recession, with an average fee for equity funds at 0.59% in 2017, according to the Investment Company Institute.
- Equity funds can serve multiple investment goals. Equity funds can be selected for 529 plans, Roth IRAs and other investment options, as well as an individual investment account. The versatility of equity funds can make them appealing to investors who may have multiple investment accounts earmarked for various goals.
Cons of investing in equity funds
- Duplication is a possibility. If you have multiple accounts with equity fund investments, it may be possible that you’re holding more stock in one specific company than you realize. The wide exposure to positions can make it hard to understand what you own, which can make it tough to know the best moves to make to manage your portfolio.
- Low maintenance is not the same as hands-off. Even though equity funds may be lower maintenance than individual stocks, it’s still smart to look at performance, consider asset distribution, and potentially consult with an independent financial advisor to make sure that your portfolio is optimizing performance.
- Lack of ownership. While you may “own” shares of Amazon through your investment in an S&P 500 index fund, does that mean the shares are yours? No. You own shares of the fund, which can be frustrating for people who may want to track the performance of a specific company or try to get in early on the next Amazon.
How to invest in an equity fund
If you have a 401(k), it’s a good time to look at your asset allocation and see whether you’re already invested in equity funds. You may wish to research what your plan offers and potentially redistribute your portfolio based on your retirement goals. Roth IRAs, 529 plans and other investment accounts may already have equity fund investments as well.
If you wish to invest in equity funds, general investing advice holds true: Know your risk tolerance, do your research and know your financial goals. While costs may be lower than they were in the past for equity funds, it makes sense to compare fees, fund options and management style between brokerages.
Finally, it may make sense to invest in several equity funds as part of your overall investment strategy. For example, because of their relative predictability, some investors decide to make a large-cap index fund the core holding of their portfolio, and then allocate smaller percentages to other fund options.
Deciding whether equity fund investments are right for you
Equity fund investments may not be flashy, but low investment minimums, low-touch management, and exposure to a wide array of publicly traded companies, global markets and specialty sectors make equity funds an appealing investment option.
While some equity funds, such as index funds, can be a good choice for conservative investors, other options like emerging global markets or small-cap index funds can appeal to investors who don’t mind some risk. Tracking equity fund performance over time can also be a way to familiarize yourself with how certain companies perform, and can help make you an informed investor if you do eventually wish to buy individual stocks.