By Kristina Russo | American Express Credit Intel Freelance Contributor
6 Min Read | February 1, 2022 in Money
Equity mutual funds are the most popular type of mutual fund, providing a simple way to invest in large portions of the stock market.
Most equity funds fall into one of five categories, which are determined by the fund’s goals and investment strategy.
Balanced mutual funds are a hybrid option, mixing equity and debt holdings.
Are you curious about investing in mutual funds? Perhaps you’ve heard terms like “small cap growth fund” or “large cap equity fund” and weren’t quite sure what they mean. You’re not alone. Nearly half of U.S. households own shares in mutual funds, but the other half may be wondering whether mutual funds are right for them and which of the roughly 8,000 mutual funds they should choose.1,2
Since 60% of all mutual fund assets are held in equity mutual funds, understanding the different types of equity – aka stock – funds might be a good place to get started.3 Let’s take a look.
Mutual funds are commonly described as a pool of “financial instruments” that is managed by an investment firm. The “instruments” in an equity mutual fund pool are the stocks of publicly traded companies. Fund managers buy and sell stocks within the fund, generally trying to achieve better returns than the overall stock market. Investors buy shares of that pool when they buy a mutual fund share.
Equity mutual fund shares increase in value if the market price of the stocks inside the fund rises – called capital appreciation – or if the stocks issue dividends that are reinvested in the fund. You make money by selling your mutual fund shares at a higher price than you bought them.
Equity funds are an easier way to invest in the stock market than picking individual stocks, so they attract a large percentage of beginning investors. But their built-in stock diversification attracts seasoned investors, too. As a result, 20% of all publicly traded U.S. corporate equities are held within mutual funds.4
Because owning a share of an equity fund is akin to buying a small piece of each stock inside the fund, it’s important to understand the fund’s stated investment goal and its underlying investment holdings. The name of an equity fund typically suggests what its holdings and goals will be.
Most equity funds can be classified into one of five categories based on the fund description. These categories are:
Equity mutual funds can invest in companies of all sizes but often have a focus on one size of company. Market “cap” relates to the size of the companies whose stocks the fund owns, not the size of the fund. There are three different types of equity funds differentiated by market cap:
Occasionally, terms like mega-cap and micro-cap are used to describe company sizes at the extremes of the size spectrum.
Investment managers sometimes choose their investments based on a company’s stage in its life cycle.
“Growth” funds invest in growth-stage companies – those expected to grow at a faster rate than the overall stock market. Unrelated to size, their expected growth relates to their industry or something unique in the company’s business strategy. Growth funds take a buy-and-hold strategy, which means they own a company’s shares for a long time, hoping for stock price appreciation.
“Value” funds take an opposite approach, investing in well-established companies that may grow slowly and whose shares are trading at what the fund manager believes is a bargain price – below where they should be. Value stocks often pay dividends, which equity fund shareowners can reinvest or cash out as income, causing some value funds to be called “income funds.”
Equity mutual funds invest in domestic companies, international companies, a combination of both, or a subset of either. A “global” mutual fund – aka “world” fund – invests in both foreign and domestic companies. An “international” fund focuses on foreign companies only. “Regional” funds buy stock in companies in a particular part of the world, like Latin America or Asia, and country-specific funds further concentrate in a particular country. Equity funds buy stocks from around the world as a strategy to increase diversification and earnings opportunities. This strategy may also increase risk from international economics and politics.
“Index” funds are equity mutual funds purposely built to mirror a stock market index, such as the S&P 500, the Dow Jones Industrials, and the Russell 2000. Once established, index fund managers use a “passive” investment strategy, meaning that instead of actively picking new stocks for the fund, they manage the relative weights and values of each stock within the fund so that it reflects the benchmark index. As a result, most index mutual funds have lower management fees than actively managed equity funds. The trade-off for index funds tends to be slower, measured growth over the long term.
There are many types of specialized equity mutual funds, most of which are industry-specific or use a particular filter for choosing stocks. “Sector” funds, for example, focus on a single industry, like technology or health care. “ESG” funds offer socially responsible investing opportunities for companies that meet certain criteria for environmental, social, and governance policies. Such specialized funds come with a trade-off: It’s generally accepted that as investing focus narrows, the built-in diversification within an equity mutual fund declines.
The five categories of equity mutual funds described above invest solely in stocks of publicly traded companies. Some investors prefer mutual funds that add debt instruments, like bonds, into the fund mix.
Balanced funds are mutual funds that invest in both equities and bonds, usually according to a fixed ratio. Balanced funds, sometimes called “asset allocation” or “hybrid” mutual funds, can use any kind of allocation ratio, though the most common is 60% equities and 40% bonds. In general, balanced funds are considered increasingly conservative – which is code for less risky – as their percentage of equity holdings decrease and bond holdings increase.
“Target-date” funds are a type of balanced fund that automatically reallocates by increasing its bond component while reducing its equity component as its target date gets closer. This type of mutual fund is often used for long-term goals that have natural target dates, like college or retirement savings.
Balanced funds tend to be lower risk than pure-play equity funds, but they also tend to have higher fund expenses. When choosing balanced funds, experts recommend comparing expense ratios because even small differences in fees can cause significant differences in returns over time.
3 “Mutual Funds and the U.S. Equity Market,” Federal Reserve Bulletin