The original risk asset and the core component of almost all investor portfolios, equities and equity markets are the lifeblood of investing. But how much do you really understand about equities, how they work and what drives returns? Let’s talk about it.
Back to basics
Also known as stocks or shares, equities represent ownership of a share of a company; owning equities makes you a shareholder.
Equities for publicly listed companies are traded on a stock exchange - a forum within which brokers and traders can buy and sell securities. The earliest example of a stock exchange was built in Amsterdam, opening in 1611. The exchange was essentially an open courtyard within which traders conducted their business. This exchange (the Hendrik de Keyser Exchange) remained the centre of trade in Amsterdam for over 200 years.
Today, trade has evolved outside of a physical courtyard and most exchanges offer electronic dealing. You’re probably most familiar with the UK’s London Stock Exchange, the US’ New York Stock Exchange or Japan’s Tokyo Stock Exchange, but there are a total of 60 stock exchanges globally.
Capital and income returns
Equities have earned their place as a cornerstone for almost any investment portfolio because of their potential to deliver competitive (if not superior) returns over the long term.
Investors choose equities because they are seeking investment returns; the potential returns from equities, or the potential upsides, come in two parts; capital and income returns. Capital returns, or capital growth, is the increase in the value of your equity assets (or your shares) over time. Income returns, or the yield, is the return that an investor will receive in the form of dividends. These dividends can either be withdrawn or reinvested into the market.
Of course, there’s no such thing as a free lunch. Whilst equities typically outperform most other asset classes (and almost certainly cash and bonds) over the long-term, in the shorter-term equity market valuations experience volatility and your investments can fall in value. Depending on the timing of market fluctuations, this may mean that you get back less than you originally invest if you need to cash in or withdraw from your investments when markets have fallen.
Sentiment is key
An important thing to remember when investing in equities is that the price of any particular stock is driven by supply and demand. If more people want to buy that stock, the price will likely be pushed up. If more people want to sell a particular stock, the price will go down. The driver of markets is investor sentiment.
Investor sentiment - whether a stock or an index is in high or low demand - is forward looking. What this means is that investors will make decisions on what they think will happen next, not what has already passed.
For example, in 2016 the UK voted to leave the European Union. When the UK stock market opened the following morning, after an initial and short-lived drop, we actually saw the FTSE100 go up. This happened because of the sharp depreciation in sterling (GBP) after the ‘Leave’ result, investors recognised that this would actually be good news for FTSE100 companies. Approximately 75% of the FTSE100’s constituents’ revenues come from overseas. As a result, a weak pound will result in higher earnings when those overseas revenues are converted back to sterling. So whilst the Brexit result was broadly seen as negative news, the forward-looking outlook for the FTSE100 was positive and investor sentiment reflected this (with prices going up).
A more recent example is the collapse of Silicon Valley Bank (or SVB) earlier this month. This triggered concern for banking stocks in general, with fears that other banks may be facing the same headwinds. In the days that followed the collapse, we saw markets fall, notably banking stocks and financials. This is not because of the facts of what happened within SVB, but rather the concerns that investors have looking forwards.
Sentiment is based on what investors think will happen next, not what’s happening right now.
Risk & reward
As we’ve mentioned already in this article, equities are the core foundation for many investors when it comes to building their portfolio. This is due to the fact that over the long term, historically* equities have delivered a superior return to almost any other asset class.
However, this potential for future returns doesn’t come without cost; equities are one of the most volatile asset classes. So whilst, yes, there is potential for long term reward when investing in the stock market, investors should be prepared for the value of their investments to both rise and fall in the shorter term.
Importantly too, the level of expected volatility varies depending on the types of equity assets that an investor buys. Generally speaking, emerging and frontier markets will be more volatile and sensitive to geopolitical events than well established developed markets (you can read more about emerging and frontier markets here). Likewise, larger companies are generally more stable than smaller companies.
The higher-risk equities, such as emerging and frontier markets, smaller companies and niche sectors are often selected by investors because of their greater long-term upside potential. These regions and sectors have more room for growth because they are not yet established. But it is important that investors also understand that they carry greater risk of loss as well. During a period of economic stress, it is likely that smaller companies or emerging markets will be harder-hit.
Investors should therefore be mindful of potential losses, as well as potential gains, when building their equity portfolio and make sure that they are allowing sufficient time horizon and diversity to withstand short-term losses.
*Please remember, past performance is not a guarantee for future returns.
How to access equity investments
Some investors choose to invest in single-line stocks and they do so either via a stockbroker or via an investment platform. There are however various fees and levies associated with buying stocks to bear in mind. Investing in individual companies also carries a fair amount of risk, as you are concentrating your assets and it can be difficult to achieve sufficient diversification. Many investors thus choose to invest via funds rather than stocks.
At TILLIT, we believe that long term success for personal investors lies in funds. So let’s take a look at some of the ways you can start your search for an equity fund. Please note that the below categories (e.g. Passive, Active, Sector-specific) are not mutually exclusive. For example, a fund can be actively managed with specific parameters on its regional allocation, sector allocation and style.
Passive & Active funds
Trackers, also sometimes referred to as passive funds, aim to replicate an index (e.g. the FTSE100 or the S&P500) or an otherwise predetermined group of assets. Passive funds are often cheaper than active funds as there are no research costs and fewer management costs involved in their management. Some investors argue that passive funds are a better bet, as they allow you to easily access the return of an index at a low cost, with no risk of underperformance (note: there will always be some tracking error with passive funds but this is typically a few basis points each year). You can view the passive funds available on TILLIT here.
Other investors argue that passive funds guarantee that you won’t outperform the index and that active funds are a better bet. Active funds are those managed by one or more fund manager who use their judgement and expertise to pick which investments to buy and sell within the fund. The fund will aim to provide a better return than the benchmark after fees have been deducted. Not all active funds will outperform their benchmark so choosing the right fund is key. You can view the active funds available on TILLIT here.
Style specific funds
Style specific funds focus on providing investors with a particular outcome in mind, or a particular style of investing. This could mean that the fund is focused on delivering income for its investors, or perhaps it is investing with a Value or Growth style bias. Within equities in particular, you may also see different funds investing in different sized companies. For example, you may find a small-cap fund, looking to invest in smaller companies, or a mega-cap fund which will only invest in the largest companies in the market.
You can view all equity funds available on TILLIT here, and use the Equity style filter to narrow down your search.
Country or region-specific funds
All funds will have a predetermined region within which they will invest. This ‘region’ can be as large as the world, with globally-invested funds, and as narrow as a single country.
Individual country-funds can be useful for investors who want to gain exposure to a particular economy. This might be because they wish to have a ‘home bias’ to their own domestic economy, or because they believe that there is an opportunity that is specific to a single country (this might be as a result of a political change, for example).
Most investors will look at their regional allocation at a higher level than individual countries, however, and focus on specific regions. For example, developed markets, European equities, emerging markets, Asian equities or frontier markets.
You can view all equity funds available on TILLIT here, and use the Region filter to narrow down your search.
Within equities, you will find lots of funds that focus on a particular sector or theme, rather than a particular region or company size. This allows you to achieve more focus on that particular sector. Some examples include funds that focus on a particular sector such as healthcare or that invest in private markets.
As a result of investing with a narrower focus on a particular sector of the market, sector-specific funds may be more volatile than their regional counterparts as they have less opportunity for diversification. Typically, investors will use sector-specific funds alongside broader fund allocations with their portfolio.
You can view all equity funds available on TILLIT here, and use the Theme and Sustainability filters to narrow down your search.
Concentration & duplication
When it comes to investing in funds, another thing that investors should be mindful of is concentration, duplication and diversification. There are more funds available to investors than there are individual stocks, so it goes without saying that you will almost always have some overlap with underlying holdings across the funds you buy. This is particularly true if you’re buying multiple funds that invest in the same region.
Whilst this overlap isn’t necessarily a bad thing, it is something to keep an eye on to ensure that you don’t accidentally become concentrated in a particular company or style of stock (unless, of course, that’s what you’re trying to achieve!). Most funds make their top 10 holdings available in their factsheets and regular reports and where possible; we also share this information on TILLIT in the ‘Breakdown’ section of the individual fund pages. If you’re keen to keep an eye on overlap between your fund investments, this can be a good place to start.
Concentration can be something that investors actively look for, indeed some fund managers run ‘Concentrated’ strategies where they have a deliberately small number of high-conviction holdings within their portfolio. But it is important to remember that diversification is one of the best risk-management tools available to investors and overly-concentrating your portfolio will reduce your diversification.
Whichever path you take when it comes to allocating to equities, they are the core building block on which almost every portfolio is built. Understanding the associated risks, as well as the potential rewards, and being mindful of how equities behave is key to creating an investment strategy that you can stick to.
Date of publication: 16th March 2023
The information in this post is not financial advice, it is provided solely to help you make your own investment decisions. If you are unsure about whether an investment is appropriate for you, please seek professional financial advice. You can find more information here.
When you invest you should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return.