What Is an Equity Fund? Everfi Explains Key Concepts

Investing in stocks can be complicated, especially for those without the time or expertise to research individual companies. Equity funds offer a way to invest in a diversified portfolio of stocks managed by professionals, making them a popular choice for both beginners and experienced investors.

These funds come in various forms, each with different strategies and objectives. Understanding how they work, their costs, and potential tax implications is essential before investing.

Definition and Criteria

An equity fund pools money from multiple investors to buy shares of publicly traded companies. These funds provide stock market exposure while spreading risk across a diversified portfolio. Unlike buying individual stocks, where returns depend on a single company’s performance, equity funds hold a mix of stocks, reducing the impact of any one company’s success or failure.

To qualify as an equity fund, a significant portion of its assets must be allocated to stocks. In the United States, mutual funds and exchange-traded funds (ETFs) that primarily invest in equities are regulated by the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940. These funds must follow diversification rules to prevent excessive exposure to any single stock or sector. A fund classified as “diversified” under SEC rules cannot invest more than 5% of its assets in any one company.

Equity funds can be structured as open-end or closed-end funds. Open-end funds continuously issue and redeem shares based on investor demand, while closed-end funds have a fixed number of shares that trade on an exchange like stocks. Open-end funds are priced at their net asset value (NAV) at the end of each trading day, whereas closed-end funds may trade at a premium or discount to NAV based on market demand.

Structure and Management

An equity fund’s structure determines how investors buy and sell shares and how fund managers make investment decisions. Most are overseen by a portfolio manager or team responsible for selecting stocks, adjusting allocations, and ensuring the fund aligns with its objectives. Managers use financial analysis, market trends, and economic indicators to decide which securities to buy and sell. Some funds rely on algorithms and data models, while others focus on fundamental analysis, evaluating company financials, management quality, and industry conditions.

Governance ensures transparency and protects investors. These funds are typically managed by an investment company that appoints a board of directors or trustees to oversee operations. The board ensures the fund adheres to its investment mandate, complies with regulations, and operates in shareholders’ best interests. Fund managers must follow the fund’s prospectus, which outlines its strategy, risk profile, and permitted investments.

Liquidity management is also key. Since investors can enter or exit open-end funds at any time, managers must balance investing in growth opportunities with maintaining enough cash or liquid assets to meet redemption requests. This often involves holding a portion of the portfolio in highly liquid securities, such as large-cap stocks or short-term government bonds, to avoid forced selling during market downturns.

Categories of Equity Funds

Equity funds vary in strategy and risk profile. Some aim to mirror the performance of a market index, while others seek to outperform the market by selecting stocks based on growth potential or industry trends.

Index-Focused

Index-focused equity funds, or index funds, aim to replicate the performance of a specific stock market index, such as the S&P 500 or Nasdaq-100. Instead of actively selecting stocks, these funds hold the same securities as the index they track, maintaining the same weightings. This passive approach results in lower management fees, as there is minimal trading and research involved.

One advantage of index funds is cost efficiency. The expense ratio, which represents the annual cost of managing the fund as a percentage of assets, is typically below 0.10% for major index funds, whereas actively managed funds often charge between 0.50% and 1.50%. Lower fees mean investors keep more of their returns over time. Additionally, index funds have lower portfolio turnover, reducing taxable capital gains distributions.

While index funds provide broad market exposure and tend to perform in line with their benchmark, they do not protect against market downturns. If the index declines, the fund’s value will drop accordingly. Investors seeking market-matching returns with minimal costs often favor this type of fund, particularly for long-term strategies such as retirement savings.

Active Growth

Active growth equity funds focus on companies with strong potential for above-average earnings expansion. Fund managers analyze financial statements, industry trends, and economic conditions to select stocks they believe will appreciate in value. These funds often invest in companies with high revenue growth rates, innovative products, or competitive advantages.

Unlike index funds, active growth funds involve frequent buying and selling of stocks, leading to higher transaction costs and management fees. Expense ratios for these funds typically range from 0.75% to 2.00%, depending on the level of research and trading activity. Additionally, because managers actively adjust the portfolio, these funds may generate more taxable capital gains.

Performance varies based on the manager’s skill and market conditions. While some active growth funds outperform the broader market, others may struggle, particularly during economic downturns when high-growth stocks tend to be more volatile. Investors considering these funds should review historical performance, management tenure, and investment strategy before committing capital.

Sector-Specific

Sector-specific equity funds focus on a particular industry or market segment, such as technology, healthcare, or energy. These funds allow investors to gain targeted exposure to sectors they believe will experience strong growth. A technology-focused fund may invest heavily in companies like Apple, Microsoft, and Nvidia, while a healthcare fund might hold shares in pharmaceutical and biotechnology firms.

Because these funds are less diversified than broad-market equity funds, they carry higher risk. If the chosen sector underperforms, the fund’s value may decline more sharply than a diversified portfolio. For instance, during the 2008 financial crisis, financial sector funds suffered significant losses, while during the COVID-19 pandemic, healthcare and technology funds saw substantial gains.

Investors considering sector-specific funds should assess their risk tolerance and investment horizon. These funds can be useful for those looking to capitalize on industry trends but should generally be part of a broader, diversified portfolio.

Distribution of Gains

Equity funds generate returns through capital appreciation and income distributions. Capital appreciation occurs when the value of the fund’s holdings increases, leading to higher share prices. Investors who sell their shares at a higher price than their purchase cost realize capital gains, which may be subject to taxation depending on the holding period.

Income distributions come from dividends paid by companies within the fund’s portfolio. Some funds pass these dividends directly to shareholders, while others reinvest them to purchase additional shares, a strategy known as a dividend reinvestment plan (DRIP).

Dividend distributions vary by fund strategy. Growth-focused funds may reinvest earnings into expansion rather than paying dividends, while dividend-oriented funds prioritize companies with consistent payout histories. Investors should review a fund’s dividend yield to assess expected income.

Net Asset Value and Expenses

The net asset value (NAV) of an equity fund represents the per-share value of its holdings after accounting for liabilities. It is calculated by taking the total market value of the fund’s assets, subtracting any outstanding expenses, and dividing the result by the number of shares outstanding. Open-end funds continuously issue and redeem shares, causing NAV to fluctuate daily. Closed-end funds, in contrast, trade on exchanges at prices that may differ from their NAV due to supply and demand.

Expenses affect investor returns. Management fees, administrative costs, and distribution expenses are deducted from the fund’s assets, reducing overall performance. The expense ratio, expressed as a percentage of assets under management, varies widely. Actively managed funds typically have higher expense ratios due to research and trading costs, while index funds and ETFs tend to be more cost-efficient. Investors should also consider transaction fees, such as front-end or back-end sales loads, which impact the total cost of ownership.

Tax Matters

Taxes on equity fund investments depend on the type of gains realized and the investor’s holding period. When a fund sells stocks at a profit, it may distribute capital gains to shareholders, who must report these earnings on their tax returns. Short-term capital gains, from securities held for one year or less, are taxed at ordinary income rates, while long-term capital gains, from assets held for more than a year, benefit from lower tax rates.

Dividend income is also taxed, but the rate depends on whether the dividends are qualified or non-qualified. Qualified dividends receive favorable tax treatment, with rates matching those of long-term capital gains. Non-qualified dividends, such as those from real estate investment trusts (REITs), are taxed at ordinary income rates. Investors can minimize tax liabilities by holding equity funds in tax-advantaged accounts, such as IRAs or 401(k) plans, where gains and dividends can grow tax-deferred or tax-free.