Equity Funds: What They Are, How They Work

Curious about investing? Your first instinct may be to plunk that money into the hot company stock of the moment, but for most investors, the wiser course would be to put that cash into a basket of stocks called an equity mutual fund or an equity fund.

What is an equity fund?

An equity fund (sometimes known as a stock fund) is a single investment that holds a number of different individual stocks. Equity funds have thousands of investors who purchase shares of the funds, and the funds buy stocks in a range of companies.

Equity in a company is like the equity that homeowners have in their house; each speaks to a degree of ownership of the asset. Equity funds give investors fractional ownership of companies via the shares they purchased in the fund.

Equity funds are often used in investment portfolios and are one of the most popular types of mutual funds.

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What is the benefit of investing in equity funds?

Equity funds are an easy and economical way to invest in the stock market.

While equity funds aren’t immune to market swings, they can offer a smoother ride. With funds, you're spreading your investments across a range of companies, sectors, or the whole market. If one company in the fund suffers, stronger performance by others can mask the loss and your portfolio can still go up.

Like all mutual funds, equity funds also offer a way to build a diversified portfolio at a lower investment minimum. The average investor doesn’t have the time or cash to build a broad portfolio one stock at a time — the high share prices of some individual stocks may mean you can only afford to invest in one or two companies. Mutual funds allow you to invest in small pieces of a lot of different companies, offering you more diversification for the same amount of money.

What is the difference between an equity fund and a stock?

Individual company stocks and equity funds are both ways to own a piece of publicly traded companies, and the attraction of both can be summed up in one word: growth. Buying and holding onto stocks or equity funds over time is a key ingredient in saving for retirement.

Investing in individual stocks requires deep research and a strong appetite for risk. The value of any one company may see more volatile changes compared with an equity fund, which is inherently diversified. Compared to equity funds, stocks can expose you to a larger financial whiplash if a stock's value were to suddenly plummet.

Direct ownership of company stock carries the potential for market-beating performance but with greater risk as well.

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How to invest in equity funds

If you decide equity funds are the right way to go, you'll be confronted with a new question: Which ones?

Equity funds are often built around themes. For example:

• Where the companies are listed:

  Index equity funds track the companies on a given stock market index, such as the Dow Jones Industrial Average or S&P 500. These help investors reap broad market gains and should roughly mirror the performance of the index they track.

• What the companies do:

  A fund that invests in a specific industry, such as insurance, pharmaceuticals, oil and gas, or technology, offers greater diversification than buying stock from just one or two companies in that sector.

• Company size:

  Some equity funds focus on the size, or market capitalization, of companies, ranging from large-cap companies such as Apple and Disney to small-cap companies that may not be household names but can produce profitable returns.

• Location:

  International or global funds invest in companies and industries around the world, allowing investors to balance declines in one market with growth in another locale.

Many investors build a portfolio with a mix of broad market funds and a few industry or geographically specific funds, depending on the individual investor's retirement goals.

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How to buy equity funds

There are several ways to purchase equity funds. One option that might be readily available to you is through an employer-sponsored retirement account, such as a 401(k) or 403(b). Your choice of funds will depend on the provider your employer chose, but many plans provide a couple dozen or so options. (Learn more about investing through your 401(k).)

You can also purchase a fund through a brokerage account or individual retirement account.

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