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Equity funds explained

How to invest in the stock market through funds, passive vs active management explained and the taxes and fees to expect.

In this article
What are equities? What are equity funds? Active vs passive equity funds How can I buy equity funds?
How to make money from equity funds What factors affect equity fund prices? Do I pay tax on equity funds?

What are equities?

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.

It's now possible to invest in thousands of companies at the same time using an equity fund.

Historically, equities have outperformed safer investments, such as bank accounts and bonds, and can act as the real driver for growth as part of a balanced investment portfolio.

 

What are equity funds?

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 tracker fund, which invest in a range of shares in different companies.

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:

 

Developed markets

 

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 
  • North America 
  • Europe 
  • Japan
  • Australia and New Zealand

 

Emerging markets

 

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.

 

Company size

 

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 times 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. 

 

Industry

 

These funds invest in particular industries, such as technology, pharmaceuticals, mining or energy, among others.

Active vs passive 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 very 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.

How can I buy equity funds?

It's possible to buy some funds directly online, or via a financial adviser or roboadviser.

If you're confident in your risk appetite and aims, however, the easiest way to buy funds is via an investment platform.

Platforms enable you to buy and hold multiple equity funds and other investments, within Isas if necessary. In exchange you pay fees, in addition to the fees charged by the equity funds.

Using customer feedback and expert analysis, we've reviewed and ranked the leading investment platforms - find our Which? recommended providers here

How to make money from equity funds

The return from equity funds comes in two forms: dividends and capital growth.

Income funds aim to regularly pay dividends to fund holders, using the money earned through company dividends. Accumulation funds use those company dividends to invest in more shares, so investors can profit through capital growth.

Against these potential gains you need to consider a number of potential costs:

  • Ongoing charge figure (OCF) - an annual fee you'll need to pay however the fund performs. 
  • Performance fees - usually levied by actively-managed funds, these typically take 20% of everything above a certain level of performance
  • Trading fees and stamp duty reserve tax - paid when a fund buys or sells a share
  • Exit fees - charged by some funds should you decide to sell your investments

You can find out more about fees and how they affect your investment performance here.

What factors affect equity fund prices?

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 - and hence equity funds that hold the company. Conversely, if the prospects aren't looking good, the share price can fall.

The wider economy is also influential on equity fund prices. If economic conditions are good and investors have confidence in companies' ability to grow, the demand for shares increases. 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.

Do I pay tax on equity funds?

Since April 2018, you can earn up to £2,000 from dividends without being taxed. 

After this, dividends are 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 equity funds, you might be liable to pay capital gains tax on any gains you make over £12,300 in the 2021-22 tax year.

Of course holding equity funds in a stocks and shares Isa, junior Isa or lifetime Isa means you won't have to pay dividend tax or capital gains tax on them.

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