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Basics of Investing & Portfolio Management

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The Funds: Equities I (Caps & Styles)

Lesson 7

We will see what investment funds are and two different types of equity funds: Caps and Styles.
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The Funds: Equities I (Caps & Styles)

In the past sections, we gained an understanding of the main asset classes that you have available. Now, we will see what investment funds are and the different types of funds.

What are investment funds?

Investment funds have become one of the most popular ways to invest among Americans because they offer many perks, like built-in diversification. They are pools of securities that aim to diversify within a specific asset class, a combination of them, or a certain investment strategy. Funds are managed by professionals that follow investment strategies that match the objectives of the funds.

Let’s look at a simple example:

Imagine that, five years ago, you had $1,000 to invest and loved the clean energy sector, for instance. If you were to invest alone in individual stocks in the renewables sector you may have not been able to diversify your portfolio enough, because your capital was fairly limited and it would only take you so far. Maybe you could have bought a total of 10 stocks in 10 different companies.

However, you found nine friends who also love the renewables sector and were looking to invest $1,000 each. So you all get together and decide to pool your money (a total investment capital of $10,000) and invest it in a wide array of companies in the water industry, the wind energy industry, the solar industry, and the nuclear industry (all renewable energy industries). Now, you would have exposure to a wider range of stocks, perhaps about 100 different renewables companies, instead of 10 by investing alone.

You and your friends just created a very simple investment fund, a pool of securities that are managed to diversify within an asset class (renewable energy companies, which would be considered a sub-asset class). In this case, each investor would own a share of 10% ownership in the fund ($1,000 each / $10,000 total invested). So each one of you would receive 10% of the total gains.

One year later, the investment fund grew by 30%; so, its total value went from $10,000 to $13,000. Each one of the investors, who put in $1,000 would now have $1,300. What if, instead of $1,000, someone were to invest $1? Or $1,000,000? The value of their investment would have gone up at the same rate (30%). So, the $1 investor would have $1.30 and the $1-million investor would have $1,300,000. The same applies when the value of the fund goes down.

In real life, there are many kinds of investment funds (mutual funds, exchange-traded funds, hedge funds, etc.) and they are much more complex, they are formed by many investors with millions of dollars invested and really high Net Asset Values (NAV, or the total value of a fund’s assets, which would be $10,000 in our example). Investment funds are professionally managed and, therefore, have some set fees in the form of the Management Expense Ratio, the annual fees a fund charges its shareholders. That is why it is important to shop around and look for funds with low fees; otherwise, they may really eat up your profits in the long run. We will discuss this further in future sections.

Types of Investment Funds

There are many types of funds. We will break them down into the four most important broad types, which are made of the big three asset classes we saw in earlier sections.

Equity Funds

These are funds that buy and sell stocks, or equities. These are the most popular among retail investors who aim to achieve fairly high returns and don’t mind having some volatility. Equity funds offer a lot of diversification opportunities, and they can be classified according to their investment objectives:

  • Market Capitalization

Market capitalization (commonly known as market cap) is the market value of all the outstanding shares of a company. It is used as a measure of the size of publicly traded companies. Let’s think back to Laura’s SmartPies Company. Its growth has continued and now it is partially owned by 1,000 investors (including herself) that own one share each; therefore, there are 1,000 shares outstanding of SmartPies Company.

Equity funds can be classified depending on the size (market cap) of the companies they hold. Here are the main types of funds by market cap:

  1. Large-cap equity funds:

    These funds invest in stocks of large corporations with market caps of over $10 billion. Companies of that size are more stable, generally safer and offer high dividends. However, it is important to do a thorough analysis before jumping in and buying them just because they are popular stocks. These companies are worth more than the gross domestic product of some countries. Corporations like Microsoft, Amazon, Apple, JP Morgan, Walmart, and so on, are known as blue-chip stocks and they are some of the main components of most large-cap funds.

  2. Mid-cap equity funds:

    Mid-cap funds own stocks of medium-size, public companies. These companies have a market cap between $2 and $10 billion. These funds are typically a bit riskier than large-cap funds and offer higher growth prospects. These companies aren’t that well known and are normally younger. However, mid-cap stocks are great investments when the market is in an upswing.

  3. Small-cap equity funds:

    Small-cap funds invest in public companies that have a market cap between $500 million and $2 billion. These companies tend to do very well early in market recoveries, right after a crisis. However, they are the riskiest type because information about them isn’t as easily available and they have less available cash to grow so they are more sensitive to market swings. These companies don’t normally offer dividends since they need all the money they can to grow. Public companies with market caps below $500 million are known as micro-cap stocks.

  • Investment Styles:

Equity funds that specialize in a certain investment style only hold stocks with characteristics that fit that style. For instance, imagine that, instead of renewable energy, you and your friends were really interested in exclusively achieving high returns and didn’t mind taking on risks, you could have invested your capital in stocks that grew by 50% or more every year for the past 3 years. That is a simple but very risky investment strategy, and you would have created an ultra-high growth equity fund. The most important styles that funds follow are:

  1. Growth equity funds:

    Growth funds invest in stocks of relatively young, smaller companies (although not exclusively small) that have the potential to outperform the overall market over time because they show signs of possible significant future growth. These companies normally use the money they earn to reinvest it and grow faster, offering little dividends (if any) but high capital appreciation prospects. Funds that invest in this type of stocks tend to yield high returns but are fairly risky.

  2. Value equity funds:

    Value funds focus their capital on stocks of bigger, well-established companies with deep pockets that offer high dividend yields but not such high capital appreciation prospects. These funds tend to be more stable and grow slowly but with less volatility.

  3.  Blend equity funds:

    These funds offer an even higher level of diversification by allocating a part of their capital to growth stocks and another part to value stocks. They are useful for investors of different risk tolerance levels. People that want somewhat high returns but do not wish to bear with the high risk of strictly investing in growth funds would choose to invest in a 60/40 fund, which allocates 60% of the capital to growth stocks and 40% to value stocks. Or, equity investors that are on the conservative side but want to have a bit of exposure to higher expected returns would invest in 10/90 equity funds, 10% in growth stocks and 90% in value stocks.

It is worth mentioning that, even though growth stocks are expected to outperform the market in the long run, value stocks may perform better in certain periods of economic distress due to their lower volatility.

In the next section, we will continue talking about the most important categories of equity funds and then we will start digging into other classes of funds.

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