How investing works
Equity funds explained
By Michael Trudeau
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Equity funds explained
The traditional way to invest is to buy shares in companies. As a shareholder, you have an equity stake in a business, which is why shares are also known as equities.
Historically, equities have outperformed safer investments, such as bank accounts and bonds, and can act as the real driver for growth in your investment portfolio.
However, investment in shares exposes you to the potential to lose some, or all, of your money. Shares are seen as the riskiest asset class, so you should take extreme care when you consider investing in equities and the different types that are available.
The benefits of shares
Shares are issued by companies as a means of raising money. Essentially, companies are selling part of their business to investors, and shares offer people outside the company the opportunity to receive profits if the company is successful.
As you have become a part-owner of the company, you have certain voting rights and are sometimes eligible for certain perks beyond the receipt of profits, such as discounts on products and services. But generally, you have very little say in how the company is run.
Different types of shares
There are two types of company shares you can purchase:
- Ordinary shares: purchasing ordinary shares makes you a part-owner of the company and entitles you to dividends. These are effectively a share of the companies' profits that are paid out to shareholders once it has met all of its other obligations. Companies aren't obliged to pay dividends, however, and even if they do, they can cut them at any time. Most ordinary shares are voting shares, meaning you also get a say on matters relating to the company, such as directors' salaries or whether to agree to a takeover.
- Preference shares: these shares carry no voting rights but, as the name suggests, entitle you to other rights. Preference shareholders usually get a share of the profits before ordinary shareholders, usually as a limited amount defined by the issuing company. In addition to this, preference shareholders – although near the end of the line for any payout – do get any money paid out before the ordinary shareholders if the company goes bust. Preference shares are generally seen as less risky and payouts are therefore generally lower than ordinary shares.
How to buy shares
You can buy shares directly through a stockbroker registered with the Financial Conduct Authority. You can also invest in equity funds using a fund supermarket.
Find out more: Fund supermarkets reviewed – read our unique reviews of leading brokers
Equity funds explained
Direct investment in shares can be risky, as you're reliant on the performance of a relatively small number of companies.
Therefore, you may want to consider buying equities through an investment fund, like a unit trust or open-ended investment company (Oeic), investment trust or exchange-traded fund (ETF), which invest in a range of shares in different companies.
Find out more: Different types of investment – learn more about your options
Equity funds tend to focus their investment on various countries, regions, industries and investment styles as a way of diversifying, or spreading risk. There are a number of different types of equity funds, each with their own characteristics and level of risk.
Equity funds can be generally split into the following categories:
These are the countries that are thought to be the most economically developed and therefore less risky. That does not mean, however, that investing in them is without risk. What's more, it's important to note that some companies listed in developed markets may not primarily do business in that country. It's possible that most of their business is in emerging markets, but they choose to list on one of the world's leading stock exchanges. The following are considered to be developed:
- UK – funds invest in companies listed in the UK. Some invest for growth, while others will look to produce some growth and income (usually by investing in companies that pay high dividends).
- North America – funds invest in companies listed in North America.
- Europe – funds invest in companies listed in Europe. Some funds include the UK, others don't.
- Japan – funds invest in companies listed in Japan.
These are the countries that are less economically developed and are much more volatile to invest in. However, they may offer the greatest potential for growth as their economies grow. Funds investing in emerging markets invest in some or all of the following:
- BRIC – Brazil, Russia, India and China, the four leading emerging markets.
- Asia Pacific – funds invest in countries in Eastern Asia, such as Korea, Vietnam and Indonesia. These funds usually exclude Japan.
- MENA – refers to investment in the Middle East and North Africa.
Some funds invest according to market capitalisation, meaning the size of the companies they're interested in (calculated from the number of ordinary shares in circulation x the current share price).
- Large-cap – large, or 'blue-chip', companies tend to pay regular dividends and offer the potential for steady growth in their share prices. They're usually worth more than £10bn.
- Mid-cap – medium-sized companies, slightly riskier than large-cap companies but could still pay dividends and often have greater potential for growth.
- Small-cap – small companies are much riskier, as there's a far greater likelihood they could go bust. Generally, small-caps don’t pay dividends but, if they're successful, share prices can rise dramatically.
These funds invest in particular industries, such as technology, pharmaceuticals, mining or energy, among others.
Find out more: Which? investment portfolios – we have created a set of investment portfolios that can help you decide where to invest your money, balanced with how much you're willing to put at risk.
How to make money in equities
The return from shares comes in two forms: dividends and capital growth.
- Dividends: dividend payments are the distribution of the profits that the company has made, usually paid out twice a year. You're more likely to receive dividends from larger, long-established companies – the more profitable it is, the larger the dividend payout could be. Smaller companies are less likely to pay out a dividend as they reinvest their profits to grow their business. However, if a smaller company succeeds, the value of your shares could increase.
- Capital growth: you can make a profit if you sell your shares for a higher price than you paid for them. This provides you with capital (the money you invested to begin with) growth.
What factors affect share prices?
The price of your shares is affected by both internal and external factors.
Companies publish their financial results at least once a year, as well as publishing trading updates and announcements of dividend distributions for the future. If the company is performing well and is expected to do so in the future, this should have a positive effect on the share price. Conversely, if the prospects aren't looking good, the share price can fall.
The wider economy is also influential on the share prices. If economic conditions are good and investors have confidence in companies' ability to grow, the demand for shares increases. This market sentiment and investor demand for shares can increase the price. The more that demand outweighs supply, the higher the share price can go.
Of course, if the economic climate is not good, investors may not be so confident in the prospects of a company. Therefore, the share price can fall, even if the company is performing well.
Tax on shares
In his July 2015 Budget, the Chancellor announced reform to how dividends are taxed. Starting at the beginning of the 2016-17 tax year, investors will receive a £5,000 allowance, meaning the first £5,000 of dividend income will be tax-free.
After this, dividends will be taxed at 7.5% if you are a basic-rate taxpayer; 32.5% if you are a higher-rate taxpayer; and 38.1% if you are an additional-rate taxpayer.
When you sell your shares, you might be liable to pay capital gains tax on any gains you make over £11,100 in the 2015-16 tax year.
Find out more: Tax on savings and investment – our comprehensive guide
Understanding the stock market
To make it simple for potential investors to buy their shares, companies opt to have them listed on a stock exchange, such as the London Stock Exchange (LSE).
To be listed on the LSE, a company needs to have been trading for at least three years and have a market capitalisation (the number or ordinary shares in circulation multiplied by the current share price) of at least £700,000.
According to the LSE, there are over 1,400 companies from 60 different countries trading on the main market of the exchange.
Smaller companies are often unlisted, but some are traded on the Alternative Investment Market (AIM) or the PLUS-quoted market. They are generally seen to be more risky investments than those companies listed on the main market – their share prices are likely to be more volatile and they are more likely to go bust. And smaller companies typically don't pay dividends – they might not be making much, if any, profit yet.
Stock market indices
A stock market index is used as a way to measure the performance of shares in a particular country, region or type of industry. In the UK, the flagship stock market index is the FTSE 100. The 'footsie' measures the performance of the 100 largest companies listed in the UK. The larger FTSE All Share measures the performance of all listed companies in the UK.
There are hundreds of different indices measuring the performance of shares (and bonds, property and other assets) all over the world. They can be useful as a barometer or benchmark to judge the performance of your investment.
What does the stock market index show?
When you see a stock market index, such as the FTSE 100, it's often referred to in points. When the FTSE 100 launched in 1984, it was started at a base level of 1,000 points. The increases and decreases represent the average change in the share price of the companies that make up the index.
The FTSE has soared much higher since then – it broke 7,000 points in April 2015, for example. When the index was launched, the total market capitalisation of the companies in the index was just over £100bn; now, it is over £1.5trn – more than 15 times larger.
Tracking a stock market index
A simple way to get access to the stock market is to invest in equity funds. Some funds buy shares from all the companies in an index, or a representative proportion thereof, to track its performance. These are known as passive 'tracker' funds. They come with lower annual management charges and are relatively simple investments to own, but will always slightly underperform the stock market index because of the cost of investing in them.
Active funds, run by professional fund managers, aim to deliver returns that beat a stock market index. For this service, you pay higher annual charges but, in theory the manager will produce superior returns to make up for it. There is, however, no guarantee that active funds will beat the stock market index – indeed, few active managers are able to beat the market on a consistent basis.
Find out more: Active vs passive investment – understand the two approaches
- Last updated: September 2016
- Updated by: Michael Trudeau