What you should know about the equity fund
An equity fund is a name for a type of mutual fund. The risk level of the equity fund is higher than that of the bond funds, thus its recommended term is longer. Therefore, “in return” the expected return is also the highest among securities funds. The vast majority of the money invested here is directed to equities, so let’s take a brief look at what a stock is now.
What is a stock?
A stock is a security embodying ownership without expiration date / maturity.
If you are a shareholder, you are the owner of the company issuing the share in proportion to your shares. On stock exchanges, you can most often come across common stock, this is the “basic type” of stock.
Since you also became the owner of the company with the purchase of the share, you also become entitled to receive the profit achieved by the company, ie to receive dividends. This is only true for individual stocks, don’t expect the same from a stock fund, as you don’t own the stock here. Although the fund manager may receive a dividend on the shares, they do not distribute this among the unit-holders. Instead, they can incorporate it into the price of the equity fund.
Composition of the equity fund
The equity fund consists largely of individual shares, the remainder being lower risk assets as defined by the fund manager. Although equity exposure can be as high as 100%, the fund manager usually holds a relatively small portion in liquid assets to ensure that the redemption of units is smooth.
The aim of this composition is to achieve returns in excess of bank deposits, government securities and money market funds by ensuring high equity exposure.
Which shares can be included in the investment portfolio of a given equity fund is determined by the fund’s description. Because being called a stock, an Asian stock can bring different result than a Central European stock. Thus, the direction of investment can focus on a specific geographical region or even an economic sector.
Equity fund return
The risk of equity funds is high, which can be mitigated by extending time horizons. Accordingly, equity funds are proposed for a period of more than 5 years. During this period, their yields can be significant.
What does high risk mean?
Put on very roughly, there is a big difference in yields. Looking at the picture, you can see the 5-year results of the equity funds.
During the same period, for example, a HUF-based short-term bond fund performed as follows:
Note: the relapse in both is caused by the coronavirus rupture, the order is restored after the end of the quarantine period. The difference is in the degree of exchange rate change.
If you think for less than 5 years, you can still achieve nice results, but this is the exception rather than the rule. Don’t expect that if your neighbor has been able to realize a 20% return in the last 2 years, this will go to you in the next 2 years as well.
Equity funds are not suitable for solving your short-term financial goals with them. If you’re thinking in the short term, you can still keep money in an equity fund, but only do so to a very small extent. So if the exchange rate is going in a negative direction, nothing will jeopardize the achievement of your goals.
Equity funds are suitable for capital building based on their return prospects and time horizon. You can also do this by setting aside your money in one lump sum or by buying new units for the existing one on a regular basis.
In the picture below you can see the worldwide inflation, the average return prospects of equity funds are definitely higher.
If you look at the 10-year returns of equity funds, you’ll see that it was very “flat” (sideways) in the beginning. This only reduced your yield in nominal terms, but increased earnings for those who bought in that time period.
The reason for this is very simple: between 2011 and 2013, he received the shares of the equity fund at almost the same price, which, if well chosen, could be sold at a higher price in 2019-2020 (or even 2025). Thus, it achieves extra returns for the entire 3-year period, which is guaranteed to beat inflation.
Factors Affecting Equity Fund Yields
The performance of an equity fund depends on a lot of things. Let’s look at these in a row.
Performance of underlying stocks
The price of shares is affected, for example, by the risk arising from the operation of the company. In which industry do they work, how efficiently do they work, who make up the management of the company, what dividend policy do they have.
If you think about it, you’d also rather put your money in a place where you don’t take more risk than necessary and where they not concealing anything about your money. Other investors are like this too. They like companies that are predictable, stable, transparent and well-managed and experienced.
Depending on the country in which the fund managers of equity funds invest in the shares of companies in their portfolio, country-specific risks may appear. Examples include exchange rate and interest rate policies pursued by a country’s central bank. Through interest rate policy, they can make it more difficult or even easier to borrow, thus indirectly affecting the company’s profitability.
In addition, especially in more politically accentuated countries (eg the US), it is also important whether there will be elections in the near future. Investors love stability, so when there is the possibility of a change in the country’s governance (hence the business environment), they are reluctant to invest in equities, temporarily also re-weighting their existing investments into less risky solutions.
Think of the quarantine situation caused by the coronavirus. Many companies have temporarily stopped production. They did this either because so many of his workers became ill that they could no longer handle production, or as a precaution. The decline in production was caused by a drop in demand. Consumers either did not see their workplace as safe or could not use the product at home. So they postponed the purchase.
The performance of these companies, and through this, the price of their shares, also declined. This is, of course, a temporary state, as the fact that the investors do not see a great opportunity in it, the factories are still there, so everything restarts when the conditions turn favorable.
Equity fund risk
You can already guess some of the risks from the above, and in the same way that you list all the risks that are only slightly possible for side effects of medications. I do so now, even if there will be a risk between them that is in the deck but no one has seen it live yet.
The equity fund unit can be redeemed at any time by you and anyone else. In the event of a market panic, large sales by small investors can be expected to lead to a fall in the price of the investment fund. The fund manager must be prepared for this. This means that the fund manager even sells the underlying investments out of coercion.
Change due to interest rates
As the guaranteed interest rate available through government securities increases, investors expect higher returns for higher risk-taking. If they don’t get this, they will direct their money towards safer solutions, which will lead to a fall in the price of the stock fund. Based on the decision of the central banks, rising interest rates after raising interest rates will also have a negative effect on the exchange rate. This is because the company issuing the shares becomes more expensive to raise funds, so its profitability decreases.
Foreign exchange risk
If you are not specifically thinking only of domestic stocks, then it is natural that you also buy shares priced in foreign currency through the fund. Regardless of whether you pay in domestic currency (for example in forint), the fund manager will invest it in foreign currency (for example in dollars). If the dollar strengthens against the forint, you will get one dollar more expensive. Then you will be able to buy fewer investment units from the same amount of paid forints. This in turn affects the price of the equity fund on the one hand and the available return on the other.
Although the fund manager selects the shares that make up the equity fund’s portfolio with the utmost care, it cannot be ruled out with absolute certainty that the selected companies will not go bankrupt. The shareholders of a bankrupt company, as owners, cannot expect much good in terms of return on their investment. If this were to happen, the value of the shares of the equity fund would also decrease due to the termination of the shares that make up the equity fund.
Risk from unknown asset value
This is especially a risk in volatile markets. When you place an order for either a buy or a redemption, you do not yet know the exchange rate at which it will be executed. This can be good for you, but it can also be bad for you.
Central European stock exchanges have low turnover compared to big-name stock exchanges. Thus, if a security has not been offered for sale or purchased for some time, its price will be shown as the price of the last transaction entered into. As a result, the security will be temporarily overvalued or even undervalued.
- Have you invested in an equity fund before? What was your experience?
- For what purposes would you assign an investment for which you would choose an equity fund?
- How much of your investment portfolio would you hold in an equity fund?
Whether you need more information to make a choice or want help on the subject, you can contact us here.