Investing in Equity Funds: A Beginner’s Guide

What Is an Equity Fund?

An equity fund is a type of investment fund that pools money from investors to trade primarily a portfolio of stocks, also known as equity securities. Fund managers aim to generate returns for the fund's investors. Because of their focus on stocks, equity funds are also known as stock funds.

Equity funds offer investors a professionally managed, diversified approach to investing in stocks, with the potential for attractive long-term returns. While investing in stocks carries more risk than some other investments, a fund can diversify with stocks from many different companies, thus offering some protection from the risk of one or more of the stocks underperforming. Their growth potential attracts investors with longer time horizons who can weather short-term market changes with the patience to see higher returns over the long run.

Equity mutual and exchange-traded funds (ETFs) are often categorized according to company size, the type of companies whose stock is held, and how actively they are managed.

Types of Equity Funds

Equity funds each have their own investment strategy and management style. Two primary categories of equity funds are actively managed funds and passive funds.

Active vs. Passive

• Actively managed: These equity funds have portfolio managers who actively research, analyze and select stocks with the goal of outperforming a benchmark index, such as the S&P 500. They use their expertise and various strategies to decide whether to buy, hold, or sell stocks within the fund's portfolio. The success of an actively managed fund largely depends on the fund manager's skill and decision-making ability. Because of the more hands-on approach, actively managed funds typically charge higher fees than passive funds.
• Passively managed: These include index funds, which aim to replicate the performance of a specific market index. For example, an S&P 500 index fund seeks to mirror the returns of the S&P 500 by holding the same stocks in the same proportions as the index itself. Passive fund managers do not attempt to outperform the market; instead, they track the index as closely as possible. Because passive funds require less active management, they generally have lower fees and taxes than actively managed funds.

The choice between active and passive funds depends on your goals, risk tolerance, and investment philosophy. Some investors prefer the potential for outperformance offered by actively managed funds, while others want lower costs and market-matching returns of passive funds. Some funds offer a mix of the two to balance risk and potential returns.

Market Cap Categories

Market capitalization, or market cap, is the total market value of a company's outstanding shares. Equity funds are often categorized based on the size of the companies they invest in. Companies with different sizes tend to have distinct characteristics and risk-return profiles.

• Large-cap funds: These invest in stocks of companies with a large market capitalization, typically exceeding $10 billion, though this figure changes over time. These companies are usually well-established, mature businesses with a history of stable growth and consistent dividends. Large-cap funds are generally considered less volatile than funds investing in smaller companies, as large companies tend to have more stable revenues and greater financial resources to weather economic downturns.
• Midcap funds: These put money into the stocks of companies with market capitalizations between large- and small-caps. These companies are often in the growth phase of their life cycle, with the potential for rapid expansion and market share gains. Midcap stocks may offer higher growth potential than large-cap stocks but also carry somewhat more risk.
• Small-cap funds: These buy the stocks of companies with a small market capitalization, typically under $2 billion. These companies are often younger, less established businesses with the potential for high growth. Small-cap stocks can be more volatile and less liquid than their larger counterparts, but they may offer investors the potential for higher returns.

Growth vs. Value

Equity funds are also classified based on their investment strategy, with two main categories being growth funds and value funds:

• Growth funds invest in stocks of companies expected to have more rapid earnings growth, often characterized by higher price-to-earnings (P/E) ratios. Companies like these typically reinvest their earnings into expanding their businesses rather than paying dividends. Growth fund managers try to identify companies with new products, services, or business models that have the potential to disrupt their industries and capture significant market share.
• Value funds: These buy stocks that are considered undervalued based on fundamental analysis and often have lower P/E ratios, higher dividends, and lower price-to-book ratios. Value investors want to buy shares in companies trading at a discount to their intrinsic value, often because of temporary setbacks or market inefficiencies. These companies may be in mature industries with slower growth prospects but offer the potential for steady returns and income.

Sector and Geographic Specialization

Equity funds are categorized based on their focus on specific sectors or geographic regions.

• Sector funds invest in the stocks of companies operating within a particular industry or market sector. Examples include technology, health care, financial, real estate, energy, and utility funds. Sector funds allow you to concentrate your exposure to a specific area of the market, which can be worthwhile if you have a firm conviction in an industry's growth prospects. However, sector funds are less diversified than broad-market funds and can be more volatile since they are tied to the performance of a single sector.
• Geographically focused funds: Also known as regional funds, these buy the stocks of companies based in certain areas of the world. Domestic funds invest primarily in stocks of companies based in the investor's home country, while international funds buy stocks from companies primarily outside the investor's home country. Global funds invest in stocks of companies worldwide, including both domestic and international stocks. Emerging market funds invest in companies' stocks in developing economies such as China, India, or Brazil. Geographically focused funds allow investors to diversify their portfolios and carry unique risks, such as currency fluctuations, political instability, and differences in accounting and regulatory standards.

Benefits and Risks of Investing in Equity Funds

Investing in equity funds offers several potential benefits to investors, including the opportunity for attractive returns, diversification, and professional management. However, it's essential to understand the risks associated with equity fund investing to make informed decisions and align investments with individual financial goals and risk tolerance.

Potential Benefits

Historically, stocks have given investors the potential for higher returns than other asset classes, such as bonds and cash. From 1928 through 2023, the S&P 500, a broad measure of U.S. stock market performance, delivered an average annual total return of about 11.67% compared with 6.95% for investment-grade corporate bonds. Below, we provide a chart and table for rates of real returns over time for the S&P 500 versus 10-year Treasurys, real estate, investment-grade corporate bonds, and gold. While there have been, at times, steep drops in equities, it's typically ahead for more years than these other assets. Their long-term growth potential makes equity funds attractive to those wanting to build wealth over time.

A major benefit of investing in equity funds is diversification, a risk management strategy that involves spreading investments across a range of assets. This helps minimize the impact of any single investment's performance on the overall portfolio. By investing in various stocks across different industries and sectors, equity funds help mitigate the risks of investing in individual stocks.

For example, if you hold a single stock that experiences a significant decline in value, your entire investment is at risk. However, if you hold an equity fund that includes that same stock with many others, the impact of its decline on the overall fund performance is reduced.

Potential Risks

While equity funds offer prospects for attractive returns, they also come with risks to consider. The main one with equity funds is market risk, which is that economic downturns, geopolitical events, or changes in investor sentiment can cause prices to decline. During market turbulence, equity fund prices can fluctuate significantly, potentially leading to short-term losses for investors.

You can manage this risk by maintaining a long-term investment perspective, regularly reviewing and rebalancing your portfolio as circumstances change, and ensuring that your equity fund investments align with your risk tolerance and financial goals.

It's also essential to conduct thorough research and due diligence when selecting equity funds while considering the fund's investment strategy, management team, historical performance, and fees. Management fees and loads (commissions) can eat into your returns over time.

Tax Implications of Equity Funds

Equity funds generate returns through capital gains and dividends, which are taxed differently. Short-term capital gains, resulting from the sale of securities held for one year or less, are taxed at your ordinary income tax rate, while long-term capital gains, from securities held for more than one year, are taxed at a lower rate. Dividends can be qualified or non-qualified, with qualified dividends taxed at the lower long-term capital gains rate and non-qualified dividends taxed at the ordinary income tax rate.

You can employ several strategies to minimize the tax impact of your fund investments. One is to hold equity funds in tax-advantaged retirement accounts, such as 401(k) plans or individual retirement accounts, which offer tax benefits like tax-deferred growth or tax-free withdrawals. Another is to invest in more tax-efficient fund structures, such as index funds or ETFs, which typically have lower turnover and generate fewer capital gains distributions. Consult with a tax professional or financial advisor for a personalized tax strategy that aligns with your financial goals and investment portfolio.

How To Invest in Equity Funds

Investing in equity funds is straightforward, but it requires careful consideration and research to select the right funds for your financial goals and risk tolerance.

1. Investment Objectives and Select the Fund Style

The first step is determining your investment goals, risk tolerance, and time horizon. Your investment objectives should align with your financial goals, such as saving for retirement, funding a child's education, or building long-term wealth. Risk tolerance refers to your ability and willingness to withstand market volatility and potential losses in pursuit of higher returns. Time horizon is the length of time you plan to hold your investments before needing to access the funds.

Once you understand these factors, you can narrow down your equity fund choices. Consider the different types of equity funds available, such as actively managed, passive index, or sector-specific funds, and determine which best aligns with your goals and risk profile. For instance, a young professional with several decades before retirement might want a higher-risk growth fund with active management, while someone nearing retirement might want a more conservative value fund or broad-based index fund.

2. Research and Analyze Potential Funds

Conducting thorough research and analysis is always important for making informed investment decisions. Start by reviewing the fund's prospectus, a legal document providing detailed information about the fund's investment objectives, strategies, risks, and fees. The prospectus can typically be found on the fund company's website or through financial news and research platforms.

In addition to the prospectus, review the fund's annual and quarterly reports, which provide updates on the fund's performance, holdings, and market commentary. These reports offer valuable insights into the fund's management style and decision-making process.

Review financial news and research platforms like Morningstar, Yahoo! Finance, and Investopedia to find fund performance data, analyst ratings, and comparisons to peer funds. Pay attention to key metrics such as the fund's returns over various periods, volatility measures (such as standard deviation or beta), and risk-adjusted returns.

Consider the fund's expense ratio, which is the annual fee charged by the fund, expressed as a percentage of assets under management. Higher expense ratios can significantly impact long-term returns, so comparing a fund's fees to those in the same category is essential.

3. Start Investing

Once you have selected an equity fund (or funds) to invest in, the next step is to open an investment account. You can typically open an account directly with the fund company or through a brokerage firm that offers access to a wide range of funds from multiple providers.

• To open an account, you must provide personal information, such as your name, address, date of birth, and Social Security number. You will also need to fund the account by transferring money from a bank account or another investment account.
• Once your account is open and funded, you can buy shares of the desired equity fund. Many funds have a minimum initial investment requirement, ranging from a few hundred to several thousand dollars. Some funds also offer automatic investment plans, which allow you to invest a fixed amount regularly (e.g., monthly or quarterly) to help build your position over time.
• After placing your order, you will receive confirmation of your purchase, including the number of shares bought and the price paid per share. Monitor your investments regularly, reviewing fund performance, holdings, and relevant news or market developments. Consider rebalancing your portfolio periodically to ensure that your equity fund allocation aligns with your target asset mix and risk profile.

The Bottom Line

Equity funds offer a convenient way to gain exposure to a diversified portfolio of stocks, with the potential for higher returns than bonds or cash. Investors can choose between actively managed and passive funds, funds that invest in a range of company sizes, growth vs. value orientation, and sector- or geographic-specific funds. However, investing in equity funds also carries risks, primarily because of the stock market's higher volatility. Before investing in equity funds, it's essential to consider your investment objectives, risk tolerance, and tax situation. As with any potential investment, consult with a financial advisor to help determine how equity funds may fit within your overall financial strategy, and always conduct thorough research before making any investment decisions.