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Introduction to Mutual Funds – Equity/Stock Mutual Funds

In the previous article we had broadly seen how to conceptually classify a mutual fund. One of the questions we asked while classifying a fund was the asset class in which it invests. Does it invest in stocks, bonds, money market instruments or does it diversify across more than one asset class? One of the most popular asset class in which mutual funds invest is stocks/equity.

In this article lets continue from where we left and see the types of equity/stock mutual funds in detail. Its interesting to note that a large proportion (around 48% in 2010) of mutual fund assets are invested in equities. Other asset classes like bonds, money market instruments constitute the rest (around 52% in 2010).

Why do a large proportion of mutual funds invest in stocks?

This is because equities have had a long history of outperforming almost every other asset class by giving the best returns over longer periods of time. There are some exceptions but its a good rule of thumb that investing in stocks is one of the best options for someone looking for long term investments.

In this article, lets see how you can classify a stock mutual fund. As in the previous article, we will do so by asking a few questions.

Question 1

Does the stock fund invest in domestic stocks or does it invest in stocks of foreign companies?

Depending on which we have
1) Domestic equity mutual funds
2) International equity mutual funds

International equity funds could again invest in either emerging markets or developed markets or both.As their names suggest, domestic equity funds invest in stocks that are traded in the same country like the NASDAQ/ NYSE if you are in the US & BSE/NSE if you are in India. International equity fund invest in stocks from various countries. They could either invest in equities from emerging markets like Brazil, Russia, India, China (usually referred to by the acronym BRICs Nations) or invest in stocks from developed economies like the US, UK, Australia, Japan etc or allot a certain proportion to both emerging & developed markets.

Emerging markets are usually considered more risky than the developed markets but have better growth potential than their counterparts. It would be a good idea to allot a certain proportion of the funds to emerging markets. Apart from helping to diversify across countries, they also help to increase the returns.

Question 2

Does the stock fund invest in large established companies or mid-sized companies or smaller riskier companies with good growth potential?

Depending on which we have
1) Large-cap funds
2) Mid-cap funds
3) Small-cap funds

Here “cap” refers to the market capitalization of a company. Its calculated by multiplying the total outstanding shares to the current price of each share. For example, if the company XYZ has 100 outstanding shares and each share is currently trading at $15.25 then its market cap would be $15.25 * 100 = $1525. This basically means that the market thinks the company as of now is worth $1525.

Its a good rule of thumb that the larger the company in which you invest, the less riskier the investment. The trade-off however is that since the company has already grown to a large extent, future growth is limited. Blue-chip companies (the largest companies in a country) are well established companies and are generally considered the least risky to invest in.

In the similar manner, the smaller the company you invest in, the more growth potential it has but as a trade-off the more riskier the investment.

Question 3

How does the stock fund pick its stocks? What is its investment style? Does it look for stocks that are cheap (Value investing) or does it look for companies that are growing fast (Growth funds) or does it invest in both value and growth stocks (blend funds).

Depending on which we have
1) Value funds
2) Growth funds
3) Blend funds

Value funds concentrate on buying stocks that are “cheap” i.e. those companies that are considered undervalued and selling those that are expensive (or overvalued).

Growth funds, on the other hand, concentrate on buying stocks that have a good growth potential even though if that would mean paying a premium to buy them.

Blend funds are a mix of value and growth funds.

Question 4

Does the fund invest exclusively in a particular sector of the economy say the banking sector, the real estate sector or perhaps the pharmaceutical sector?

Depending on which we have
1) Sector funds
2) Diversified funds

Sectoral funds are those that invest in a particular sector. They are generally more riskier than diversified funds which invest across many sectors. This is because the stock prices of all the companies in a sector are usually highly correlated and any adverse event affecting the sector would impact all the stocks in it.

Question 5

Is the fund giving me regular income in the form of dividends or is it concentrated on appreciating the capital by reinvesting the profits?

Depending on which we have
1) Dividend funds
2) Growth funds

Dividend funds give out regular dividends to the fund shareholders whereas growth funds seek to reinvest the profits and increase the net value of the investment i.e. by appreciating the NAV of the fund.

Now that we have a broad overview of the types of equity mutual funds, lets explore bond funds in the next article.

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