How to Know If You Hold the Right Equity Funds

CATEGORIES: Investment Planning

Equity funds (like stock funds) are an important part of your retirement portfolio. Equities have historically outperformed fixed income securities (like bonds) over long time periods.

What does that mean for you? The longer until your retirement, the more equity exposure you’ll want. (This should, of course, be aligned with your risk tolerance.)

But before you go on equity shopping spree, here’s some information about how to analyze  funds.

Where Do Equity Returns Come From?

Equity funds provide returns through two outcomes: dividends and appreciation.

“Through what?” Don’t worry, we’ll explain.

Let’s say that you are invested in the XYZ Equity Value fund. Over the last twelve months, the price per share of the XYZ Fund gained 8%. One share used to cost $100. Now it costs $108.

During that same time period, the dividend payout per share was 2%. In other words, every $100 share that you bought paid $2.

The total return for the XYZ fund last year, then, would be 10 percent. Eight bucks comes from the appreciation. The other two comes from the dividend.

Dividends: Predictability and Stability

Equity performance is about more than just price. Dividends are a huge component of returns. They’re also generally more predictable than price gains.

Investors who are interested in earning income from their investments (we call that an “income orientation”) are going to look for equity funds whose holdings tend to pay out higher dividends. These funds advertise themselves as “high dividend” or “enhanced dividend.”

They tend to hold shares of larger-capitalized companies (that’s investor-speak for “big” companies) in mature industries. These companies have a history of paying out a high portion of their earnings as dividends.

Measuring for Growth

Are there many more years left before your retirement? If so, you are probably less interested in how much income you’ll get from your equity funds. You’re probably more interested in how they are going to appreciate before you retire.

To get some clues about appreciation, check out these two key performance measures:

1, The Price/Equity (P/E) ratio. This expresses the market price per share of a stock in relation to the company’s net earnings per share.

What does that mean? Let’s say a company earned a net $100 million in the past 12 months. Let’s also say that it has 2,000,000 common shares outstanding. That means each share represents $50 in “net earnings per share” ($100 million divided by 2,000,000 shares).

Now, let’s say you can buy one share for $500. It would have a P/E ratio of ten. In other words, the price for a single share is ten times the price of the net earnings per share in the past 12 months.

Investors use the P/E ratio as shorthand for assessing whether a stock appears cheap, expensive or at fair value. They don’t just look at each company in a vacuum; they compare the P/E ratio of one company to the P/E of other comparable companies.

Many fund managers analyze what they think a company is fundamentally worth, and compare that “fundamental value” to the current market value to determine whether or not they should buy.

2. The PEG ratio. The P/E ratio is a basis for another growth measure: the P/E-to-Growth ratio, or PEG ratio. This expresses the P/E ratio in relation to the growth the company is expected to achieve in the future.

Let’s say, for example, that Company ABC has a P/E ratio of 10 and industry analysts expect the company to grow at 5% per annum over the next three years. The PEG ratio would be 10/5 = 2.

What if analysts thought the company would grow at 10 percent? The PEG would be 10/10  = 1.

A lower PEG, all else being equal, represents a buy signal for growth fund managers. So does a lower P/E, all else being equal.

There are many varieties of equity funds, and many different evaluation techniques. Understanding dividends, P/E and PEG will give you a solid foundation.  You can use these metrics to compare funds and decide what is right for your own retirement portfolio.

Is your portfolio in line with your retirement objectives? Tell us what you think.

Find the right equity funds for your needs at, an independent online investment ranking, evaluation and portfolio management service.

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About the Author

Katrina Lamb is a CFA for Jemstep. She has over 25 years experience in economics, finance, international development and management strategy, with a strong focus on global markets. She provides a voice of clarity, logic, and reason in an environment characterized by high uncertainty.


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