Retirement

3 Tenets of Equity Funds

In my last blog, we discussed that most Millennials and GenXers will have to fend for themselves for retirement. Instead of offering a pension, most employers today offer what is known as defined contribution retirement plans (401k for businesses, 403b for non-profits like universities, 457 for government employees). Don’t let the numbers confuse you – they are just different sections of the Internal Revenue Services (IRS) tax code. Employers offer a retirement plan to employees which they can invest in for retirement and in most cases match a certain percentage of the amount the employee contributes. There are some DIY tools but mostly you are left on your own to make your investment choices.

It may sound like a daunting task but let’s look under the hood to get a basic understanding of Equity funds as an investment option for retirement.

A typical retirement plan may have anywhere between 15 to 30 investment options. In certain cases, the list may contain 100+ options. Honestly, the longer the list, the harder it is for employees to make a sensible choice. Keeping a tab and trying to understand so many options is not an easy task and requires a lot of time. And that dilemma sometimes results in inaction and you may end up parking your hard earned money in assets that don’t offer a good return or charge higher fees.

Let’s take an example of a retirement plan that has 15 options. A typical line up consists of 7-8 equity funds,4-5 bonds and 1-2 options focused on specific assets like real estate, oil & gas etc.

Let’s dig deeper into equity options. The first question in your mind may be ‘why 7-8 equity funds?’ The idea is to offer choice and diversification so that you don’t pull all your eggs in one basket.

Geography

The1st level of differentiation is geography or location. Most companies domiciled in the United States are listed on one of the US stock exchanges such as NYSE, Nasdaq etc. Keep in mind, in today’s globalized world, you will also come across foreign companies listed on US stock markets. The companies based out of Europe or Asia are listed on stock exchanges in those regions. More often than not, you will also see a fund for Emerging markets that has companies from countries such as Brazil, Russia, India, China and South Africa (BRICS).

Geography Equity view

You get the point: Location.

Market Capitalization: Size

The 2nd level of differentiation is the size. Publicly traded companies can be grouped into 3 different categories based on market capitalization: Large-cap, Mid-cap, and Small-cap. Large-cap is short for Large Market Capitalization. Think of it this way – you can relate to the size of companies based on its revenues or sales figures. The financial market determines that based on market capitalization i.e. shares outstanding X price per share. Generally, a company with market capitalization of >$10 billion is called Large cap. Common names are Walmart, Apple, Alphabet, Microsoft, Ford, GE, JPMorgan Chase etc. Mid-cap (Middle Market capitalization), usually have a market capitalization between $2 billion and $10 billion. Small-cap (Small Market Capitalization) is usually below $2 billion. Generally, Large-cap is considered more stable and less risky compared to Mid-cap and Small-cap. And Mid-cap comes after Large-cap in terms of riskiness and Small-cap companies are usually associated with the highest risk.

Market Cap Equity view

So the second differentiator is Size.

Investment Style

The 3rd differentiator is based on which stocks the investment manager has picked. These again can be of three types: Growth, Value, and Blend.  A company is considered a Growth stock if the earnings are growing at a higher rate than peers or industry and you can bank on capital appreciation in future.  Value stocks are considered to be trading at lower than the intrinsic value (bargain deals) and usually pay regular dividends. Blend style is a combination of Growth and Value. Style based funds are usually found in the funds’ lineup of the retirement plans. The fund prospectus provides details about the investment strategy of the fund.  So if you really want exact details, you may want to go through that. More often than not, the terms are written in a way that allows flexibility for the investment manager. One example is the Apple stock which may be found both in growth and value funds.

Style Equity view

The third differentiator is Style.

The above three ways to differentiate are the most basic to get an idea about Equity funds. But, unfortunately, when you start going through the list of funds in your retirement account (401k, 403b,457), you may not find a clear distinction. Instead, you will find names like Vanguard S&P 500 Index fund that will suggest it is US-based and Large-cap. S&P 500 contains top 500 Large-cap companies listed on US stock exchanges. Most Mid-cap & Small-cap funds make reference to their size, in their nomenclature.  Some retirement plans may have one International stock fund covering various geographies such as Europe, Asia-Pacific, South America and Latin America. Unless you dig deep into their offer documents, you may not always gather the level of market capitalization, geographies covered and other important information. The fund’s name is a hit or miss – it sometimes gives you the required information but not always.

Target Date Funds, Active and Passive Funds

Target date funds are also widely used nowadays which are a combination of various Equity and Bonds securities or funds. Then there are Active and Passive Funds. Active Funds pick various securities to invest based on the fundamentals or technical analysis. Some of these funds may follow top-down, bottom-up approach to select securities. Passive Funds just try to replicate indices like S&P 500, which basically means they choose to invest in the securities part of a popular equity index such as S&P 500.

After you understand the various options available, the next step is to choose the most suitable options for your retirement investment.  If you are not close to your retirement date, then you should put some of your assets in Equity funds as they offer better returns compared to Bonds over a longer period of time but keep in mind they are riskier as well.

To do all this work, some people hire a financial advisor, who may charge 0.25% to 2% of total assets, as fees. Plootus does it for free. You may ask why? We are on a mission to democratize financial planning. Our app Plootus (available on Apple and Android) will not only choose the best performers to suit your retirement needs but will also help you to decide how much to invest in the various options available to you. Our algorithm first estimates how much money you will need for your retirement period.  Sounds like a no-brainer.

That’s it for today. I know this is a lot to digest but for something as crucial as retirement planning, it is important to understand every aspect. We will look into Bonds next time.

I’m sure you will have a lot of questions as you go along. Feel free to use the comments section and we will be happy to answer any questions you may have.

Until next time!

Author: Sunil Gangwani, Co-Founder, Plootus

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http://www.Plootus.com: 10 minutes could add 50 thousand dollars or more to your retirement account!

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