In our previous write-up, we analyzed the strategies and key metrics of fixed-income funds. In the world of finance, fixed-income funds have long been favored by investors due to their stable returns and relatively lower risk profiles. However, for investors seeking higher return targets, relying solely on fixed income may not be sufficient. In contrast, the equity markets are rife with abundant opportunities, where fluctuations in stock prices can often generate substantial returns (at the price of higher risk). With their potential for capital appreciation and long-term growth, equity funds offer investors an alternative investment avenue.

In the following sections, we will delve deeper into the unique aspects of equity funds compared to fixed-income funds, exploring their investment strategies and relevant metrics. Following that, we will proceed to an example to guide investors in selecting suitable equity funds. Poseidon hopes that by introducing these topics, we can help investors better understand the equity fund landscape and provide valuable insights to guide their future investment decisions.

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Equity Funds

Equity and fixed-income funds represent distinct classes of investment vehicles, each with unique characteristics in terms of investment strategy, risk-return profile, and market suitability. Fixed-income funds primarily allocate capital to instruments that generate stable returns, such as government bonds and corporate debts. This fund category generally exhibits a lower risk profile, with a core investment strategy focused on pursuing steady interest income and capital preservation. As we all know, any investment involves a tradeoff between risk and return. While fixed-income funds provide stability, their potential for capital appreciation tends to be more constrained.

Equity funds, on the other hand, primarily invest in the stock market. Their core investment strategy centers on capital appreciation, aiming to generate returns through stock purchases and dividend income. Equity funds are typically better suited for bull markets, where the overall stock market exhibits significant gains, leading to higher investment returns. Conversely, fixed-income funds may be more appropriate for bear market conditions, as the relative stability of fixed-income asset yields can provide downside protection for investors when equity markets experience significant declines.  

Beyond the commonly used metrics like return, volatility, and Sharpe ratio mentioned in our previous article, investors in equity funds should also consider metrics specific to stocks, such as:

• Alpha: Alpha measures the excess return of a portfolio relative to a suitable market index, indicating how much better or worse the investment performed compared to the market over a specific period. An alpha greater than zero suggests the investment outperformed the market, while an alpha less than zero indicates underperformance.

• Beta: Beta represents the correlation coefficient with a market index, measuring an asset's return sensitivity to overall stock market movements. A beta greater than 1 implies that the investment's value fluctuates more than the overall stock market, indicating higher volatility. Conversely, a beta less than 1 suggests that the investment's value fluctuates less than the overall stock market, signifying greater stability. In practice, beta is often compared to the S&P 500 index.

• Price-to-Earnings Ratio(P/E): The P/E ratio is the ratio of a company's stock price to its earnings per share, used to assess its value and determine whether it is overvalued or undervalued. Generally, companies with high P/E ratios are considered growth companies, while those with low P/E ratios are deemed value companies. Over the past decade, the average P/E for the S&P 500 index has been 19.5, leading investors to consider a P/E of 20 as generally fair. However, average P/E ratios can vary across different sectors. For instance, the current average P/E for the US IT sector is a high 33, while the average P/E for the energy sector is only 13.

• Price-to-Book Ratio (P/B Ratio): The P/B ratio is calculated by dividing a company's market capitalization by its total book value (the value of all assets minus liabilities) as reported on its balance sheet. A higher P/B ratio implies that investors expect the company to generate more value from its assets. However, this ratio can vary significantly across different industries.

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Equity Fund Selection Example

Let's assume we need to choose from three equity funds: Wellington Global Quality Growth Fund (WEL GQG), Robeco BP US Premium Equities (ROB USPE), and JPMorgan ASEAN Equity Fund (JPM ASEAN).  

WEL GQG actively manages a global equity portfolio that aims to outperform the MSCI Global Index. Its stock selection emphasizes a balance of growth, valuation, capital return, and quality criteria. ROB USPE invests in U.S. stocks and seeks to deliver returns exceeding the market, focusing on identifying all-size US companies with strong fundamentals, attractive valuations, and growth potential. JPM ASEAN primarily invests in companies within the Association of Southeast Asian Nations (ASEAN) member countries to achieve long-term capital growth.

Similar to the previous article, we will also employ the Weighted Factor Rating Method to compare the three funds. Each quantitative metric will be assigned a specific weight, with the final score calculated accordingly and the fund with the higher score deemed more favorable.

For this selection process, we will primarily consider the following ten metrics: three-month return (3M Return), one-year return (1Y Return), three-year return (3Y Return), one-year volatility (1Y Volatility), one-year Sharpe ratio (1Y Sharpe Ratio), dividend yield (Div Yield), alpha, beta, price-to-earnings ratio (P/E), and fund size (Fund Size).

In the example shown, we have assigned higher scores to the more favorable metrics for investors based on their characteristics and specific rules.

For instance, the 3-month return score is calculated by dividing the fund's return by the sum of all fund returns - the higher the return, the better it is for investors. Generally speaking, a lower P/E ratio implies a cheaper stock valuation, so the P/E score is derived by dividing the reciprocal of the fund's P/E by the sum of the reciprocals of all funds' P/Es, granting higher scores to funds with lower P/E ratios.

The scoring of volatility and beta depends on the investor's risk appetite and investment objectives. For growth-oriented equity funds, high volatility carries greater risk but may also deliver higher returns; similarly, high beta indicates higher risk, but can lead to greater gains during market upswings. In the initial scoring, we have assigned higher scores to low volatility and high beta, but the weightings can be adjusted in subsequent calculations to reflect the investor's risk preferences properly.

If the investor is relatively conservative, we will assign higher weightings to volatility (20%) and dividend yield (20%). Under this scenario, the WEL GQG fund would emerge as the slightly superior choice.

For a more aggressive investor, we would place greater emphasis on returns (3M, 1Y, 3Y - collectively 30%), Sharpe ratio (20%), and alpha (20%). Furthermore, since aggressive investors are more tolerant of risk, we would apply a negative weight of -10% to volatility, such that higher volatility results in a higher score. Under this weighting scheme, the WEL GQG fund remains the most suitable selection.

If the investor seeks to balance all metrics completely, we will assign equal weights to each metric. Even in this case, the WEL GQG fund would still be the optimal choice.

In addition to referencing the quantitative scoring, investors should also consider their own investment preferences and views. Investors can choose funds focused on specific geographic regions based on their expectations for economic growth in those areas. For example, while the JPM ASEAN fund may have underperformed other funds in terms of quantitative metrics recently, if an investor has unwavering confidence in the high-growth potential of Southeast Asia, they may still opt to invest in this fund.

Investors must also recognize that past performance does not guarantee future results. Funds that have performed well historically may not necessarily continue to do so going forward. Therefore, investors should carefully examine other aspects, such as the fund's investment strategy, management team, and fee structure, to make a well-informed investment decision.

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Summary

Through our discussion on equity funds, we have recognized their potential for capital appreciation and long-term income generation. The unique aspect of equity funds lies in their stock market-oriented investment strategy - while carrying elevated risk, this approach also promises ample return opportunities.  

When selecting equity funds, investors must consider not only quantitative metrics like returns, alpha, and beta, but also the underlying market conditions and investment strategies to ensure alignment with their own risk tolerance and objectives. By conducting a comprehensive evaluation of performance, risk, and qualitative factors, investors can make more informed decisions tailored to their needs and market views.