What is an “Equity Fund”?
Equity funds are collective investment vehicles that offer investors exposure to a portfolio of equity securities. These funds can be either actively or passively managed.
Key Learning Points
- There are different types of equity funds, but the most popular are mutual funds and Exchange Traded Funds (ETFs).
- There are a large number of active and passive equity funds available in the market. Therefore, the selection process is primarily driven by the individual investor’s preferences and objectives.
- Active funds aim to outperform a benchmark index, whilst passive funds aim to replicate the performance of an index.
- One of the most attractive features that equity funds offer is risk management through diversification
- Both active and passive equity funds can coexist in a portfolio, along with other asset classes.
Different Types of Equity Funds
There are a few major types of equity funds that are commonly used by investors.
Active funds aim to outperform a benchmark or index, and the most popular type of active funds are mutual funds. These are open-ended vehicles with no secondary market; this means that investors can only buy from or sell to the fund management company. Also, prices are quoted by the fund management company on a daily basis, meaning that investors can only buy or sell their holding once a day. Mutual funds are also only required to disclose their investments on a quarterly basis, making it difficult for investors to know the funds holdings at a specific point in time.
There are a large number of mutual funds providing exposure to multiple markets, sectors and themes available to investors.
Passive funds aim to replicate the performance of a market index and there are two main types of passive fund: Exchange Traded Funds (ETFs) and Index Trackers (or ‘Tracker Funds’). The main difference between the two is that ETFs trade on an exchange like ordinary shares; this means that prices are quoted in real-time throughout the day and investors can buy or sell their holdings at any point during the day. Also, ETFs are required to disclose their holdings on a daily basis, providing a high level of transparency for investors.
Index Trackers are similar to mutual funds, which allow only daily trading and offer a lower level of transparency over their holdings.
Advantages of Using Equity Funds
There are many advantages that equity funds offer, with the main one being the increased diversification offered by a fund when compared with holding individual stocks. This helps investors to reduce the risk of exposure to specific firms.
Further advantages of using equity funds include:
- Access to expertise: Both passively and actively managed funds have a dedicated investment manager (or team of professionals) that have the expertise to run a specific strategy. For passive funds, this expertise focuses on matching returns with index performance, whilst for active funds the expertise focuses on providing returns that are in excess of the benchmark index. Investing in these funds allows investors to rely on the expertise of dedicated professionals rather than having to make their own investment decisions.
- Access to markets: Equity funds can provide access to markets that individual investors would have difficulty accessing, due to high barriers to entry or low levels of liquidity. This is particularly the case for emerging frontier markets.
- Reduced transaction costs: All investment portfolios incur transaction costs when securities are bought and sold. Equity funds buy and sell securities in larger quantities than individual investors, allowing them to achieve economies of scale and thus lower transaction costs relative to the overall size of the portfolio. These reduced costs can be passed on to investors in the form of lower fees charged by the portfolio managers. This is particularly the case for passive funds, which typically have a lower cost structure than active funds.
How to Use Equity Funds in a Portfolio
There is a wide range of equity funds, with different investment strategies and styles. This includes passive vs active strategies, funds that focus on certain markets or sectors and those which focus on a particular theme, such as an ESG investment theme.
It is up to the end-investor how to decide which investment strategies and styles suit them, and to determine how to include them in a portfolio to achieve optimal risk-adjusted results. A particularly popular approach is to use the Core-Satellite strategy, where established indices and funds (for example an S&P 500 Index Fund or an active fund investing in global equities) are used as the Core of the portfolio whilst a smaller percentage of the portfolio is used for more specialist Satellite options (for example an active fund investing in less efficient areas of the market such as smaller companies or emerging markets).
When blended with other asset classes, it should be highlighted that equities are considered higher risk investments, so having the benefit of diversification and/or professional management is often attractive for investors.