What It Is:
An equity fund is an open or closed-end fund that invests primarily in stocks, allowing investors to buy into the fund and thus buy a basket of stocks more easily than they could purchase the individual securities.
How It Works/Example:
There are literally thousands of equity funds out there and each has unique characteristics. The distinctions among funds aren't always clear, but in general, equity funds pursue one of these three primary goals: Income, capital gains, or both. To really be sure about categorizing, you must study the fund's underlying investments. However, there are a few broad categories that most funds fit into.
General equity funds include:
Aggressive growth funds, which seek maximum capital appreciation and may use speculative strategies.
Small-company funds, which invest in companies with relatively small market capitalizations.
Growth funds, which invest in larger, established but growing companies. They generally emphasize capital appreciation.
Equity-income funds, which primarily invest in dividend-paying stocks.
Other equity funds include:
Specialty funds, which invest in stocks meeting certain criteria (such as geographic region, industry sector, social causes, etc.).
Sector funds, which invest in specific stock groups, often within one industry.
Index funds, which invest in the same or similar stocks as equity market indices like the S&P 500.
International funds, which invest in foreign stocks.
Why It Matters:
One of the greatest advantages of equity funds is instant diversification. Also, it is usually easier and less expensive to invest in equity funds than to buy each and every stock in a fund's portfolio. Equity funds are also cheaper -- they're a way to avoid the often higher transaction costs and lower liquidity associated with trading individual stocks. It's often easier to sell fund shares than to sell a particular stock, especially if that stock has unusual characteristics, the issuer has a low credit rating, or the issuer is facing other turmoil. Equity funds also offer the services of a professional who watches and acts on the market on behalf of the investor, handles the trading decisions, and determines the asset allocation.
Fees, however, can eat into returns, which can already be low if the equity fund invests in lower-risk equities. In general, larger funds should have lower fees due to their economies of scale. However, small funds often take meaningful positions in smaller issues that large funds cannot or will not look at. Also, small funds are often better able to exit certain positions because they have less impact on market prices.