Equity Funds vs. Income Funds: Which Is Better?

Equity Funds vs. Income Funds: An Overview

When investing money, you’re faced with many choices. Two well-known categories of investments are equity and income funds. But what exactly are they, and which one is right for you?

Let’s start by defining them. Equity funds are pooled investments that primarily invest in stocks and offer the potential for higher returns, but they have more risk. Income funds, meanwhile, focus on generating regular income through investments in fixed-income securities like bonds or the money market. They are also used to mitigate risk. Both are among the many available mutual and exchange-traded funds (ETFs).

So, how do you decide between the two? Peter Lazaroff, an Investopedia top-10 financial advisor, cautions against thinking that income funds provide regular payments while equity funds are purely for growth or capital appreciation. He suggests that this classic financial information doesn’t fit a market with far more resources and options for investors.

“I am more interested in total returns than the income of any given product because you give me a dollar, it’s a dollar no matter what,” says Lazaroff.

Traditionally, equity funds focused on stocks for growth or capital appreciation, while income funds prioritized bonds or dividend-paying stocks for steady cash flow. However, modern portfolio theory and the emergence of blended or hybrid funds offer investors approaches that balance growth and income according to their individual risk tolerances and goals. As such, the split between income and equity funds isn’t rigid, with many investors choosing funds offering equity growth potential and income generation.

Lazaroff recommends considering your investment goals and risk tolerance before choosing different funds. “If you need current income” and “like the certainty of a dividend,” you might steer toward income funds, he says. However, he adds, “Dividends get cut in recessions, too. The range of retirement outcomes is better and broader when you take a total return approach than when you use just an income-focused approach to investing.”

Looking at the total returns means understanding the characteristics and risks of each investment, along with their tax implications—all to better inform your decisions while you build out your portfolio.

Equity Funds

Equity funds primarily invest in stocks, which represent fractional ownership in a company. Equity funds can be actively managed by those who select stocks based on research and analysis or passively manage to track a specific stock market index like the S&P 500.

Equity Fund Types

Equity fund managers choose their strategies based on their investors’ needs. Growth fund managers focus on companies with the potential to grow their earnings and expand their market share. Meanwhile, value fund managers search for undervalued stocks trading below their intrinsic worth, expecting them to appreciate over time.

Let’s break down the equity fund types. First, the distinction between growth and value investing is based on the characteristics of the companies in which the funds invest rather than their size:

• Growth funds: These focus on companies expected to grow faster than the overall market, often in sectors like technology or healthcare. They carry greater risk in return for more potential rewards.
• Value funds: These look for companies with solid fundamentals trading at a price lower than their intrinsic value.
• Blend funds: These channel money into a mix of growth and value stocks, giving a portfolio more balance.

Equity funds are also organized by the size of the companies in which they invest:

• Large-cap funds: These hold the stocks of large, well-established companies with market capitalizations typically exceeding $10 billion, though this figure changes over time.
• Midcap funds: These hold the stock of medium-sized companies, generally with market capitalizations of $2 billion to $10 billion.
• Small-cap funds: These invest in smaller companies with market capitalizations typically under $2 billion. Small caps usually have more growth potential but carry more risk.

Investors can combine investments in growth and value funds with different market capitalizations to align with their investment goals and risk tolerance. For example, an investor might choose a large-cap value fund for stability and a small-cap growth fund for potential higher returns, understanding that the small-cap fund may have more volatility.

Equity funds often focus on particular segments of the market to cater to different investor strategies and risk profiles:

• Sector funds: These focus on specific parts of the economy, such as technology, healthcare, energy, or financial services.
• International funds: These put money into stocks of companies based outside the investor’s home country, providing exposure to global markets and potentially benefiting from diversification.
• Emerging market funds: These invest in stocks of companies based in developing economies, such as China, India, or Brazil. These markets have more growth potential but also come with greater risks.

Index Funds

Given their popularity and success—S&P 500 Index funds frequently outperform their actively managed peers—it’s worth setting out these equity funds on their own. Index funds are designed to mirror the performance of a specific equity index like the S&P 500 or Russell 2000. They provide broad market exposure and diversification at a lower cost than other funds. The advantage of index funds lies in their broad market exposure, making them a go-to investment for both novice and experienced investors alike.

Risk and Return

Equity funds generally carry higher risk compared with income funds because of the inherent volatility of the stock market. However, they also offer the potential for higher returns over the long term.

The precise risk and return of an equity fund will depend on the underlying stocks in its portfolio and overall market conditions. Factors that can affect the risk and return of an equity fund thus include investment style or focus, economic conditions, market sentiment, company-specific events, and geopolitical risks. Equity funds holding small-cap or emerging market stocks often have more risk than those investing in large-cap or developed-market stocks.

How to Analyze Equity Fund Performance

Historically, equity funds have, on average, outperformed fixed-income investments over the long term. However, this depends on the time frame. In addition, past performance does not guarantee future results, and investors should carefully assess a fund’s track record and management before investing.

Here are the key metrics to review:

• Alpha: This instead measures the fund’s excess return relative to its benchmark, indicating the manager’s skill in selecting stocks.
• Benchmarks: These are comparable indexes used to gauge a fund’s performance.
• Sharpe ratio: This helps you assess risk-adjusted returns. Generally, a higher Sharpe ratio is preferred.
• Total returns: This measures the fund’s overall performance, including capital appreciation and dividends.
  
• Volatility: This measures the fund’s average price fluctuations.
  

These can all be found on many investor and brokerage platforms, including Investopedia.

Income Funds

Income funds generate regular income for investors by investing in fixed-income securities such as bonds, Treasurys, certificates of deposit (CDs), preferred shares, and money market instruments. Many use these funds to provide a steady income through interest and dividends while preserving their capital.

However, Lazaroff, host of the education podcast The Long Term Investor, says it’s a bit of a misnomer when these funds are labeled “fixed-income.” “I am a big believer that the role of bonds in a portfolio is to reduce the overall volatility of the portfolio,” he says, pointing to the major asset found in most income funds.

By putting a part of your savings into funds with bonds, CDs, and so on, you’re balancing out the heightened risks of the part of your portfolio in equities. “The fact that they’re called fixed income creates this image in our head that it should be all about the income where it’s just descriptive,” Lazaroff says.

In other words, despite the name, it’s wise to think of “income funds” as helping to keep your portfolio balanced rather than solely as a source of regular income.

Putting part of your portfolio into income funds can smooth out the stock market’s ups and downs to create a more stable investment mix. This approach can be essential for investors nearing retirement or those with a lower risk tolerance.

Lazaroff has written in Investopedia about a popular way to balance income and equity funds through the 60/40 portfolio structure. Ultimately, he says, the key is to create a well-rounded portfolio that aligns with your financial goals, time horizon, and risk tolerance.

Income Fund Types

Income funds often hold a diversified portfolio of bonds and similar securities with varying maturities and credit qualities, which helps mitigate risk.

One common strategy that income funds employ is laddering, where the fund invests in bonds with different maturity dates. This approach enables the fund to manage interest rate risk (potential losses from changes in interest rates) effectively and ensure more consistency since the bonds mature at different times and can be reinvested at prevailing rates.

In addition, income fund managers pay close attention to the credit quality of the underlying securities. They may opt for investment-grade bonds with a lower risk of default or venture into high-yield bonds, also known as junk bonds, which offer higher income potential but come with increased risk.

Income funds also manage the duration of their holdings to adjust the fund’s sensitivity to interest rate changes. In addition, some income funds specialize in specific sectors. For example, they may focus on tax-advantaged municipal bonds, which offer tax-free income to investors, or emerging market debt, which can provide higher yields but carries higher risk. Others invest across various sectors and geographies to spread risk and improve the chances of improved returns. This diversification helps mitigate sector-specific risks and capitalize on prospects in different markets.

Risk and Return

Income funds generally have less risk than equity funds since they primarily hold fixed-income securities. However, they also offer lower potential returns. An income fund’s risk and return mix depends on the underlying securities’ credit quality, interest rate changes, and the fund’s management.

Income funds are naturally exposed to a certain degree of risk, and the bond issuer may default on interest or principal payments. There’s also interest rate risk, where bond prices may fall when interest rates rise. Income funds investing in high-yield (junk) or emerging market bonds tend to carry higher credit risk than those investing in investment-grade or developed-market bonds.

How to Analyze Income Fund Performance

Income funds typically provide more stable returns in the form of regular interest payments. However, their performance will be influenced by interest rate changes and the credit quality of their securities.

While interest rates are rising, the value of existing bonds may decrease, affecting the fund’s net asset value. Conversely, bond prices may increase during periods of falling interest rates, providing capital appreciation and regular income.

Some metrics can significantly help with your assessment of different income funds. As with equity funds, there are metrics for total return and expense ratio, which is the fund’s operating costs given as a percentage of assets.

Noteworthy, too, are the measures of yield, which indicate the fund’s ability to generate income. There are several types:

• Distribution yield: This is based on the income distributed by the fund in the most recent annualized period. It indicates the income generated by the fund but is also backward-looking.
• SEC (Securities and Exchange Commission) yield: A standardized 30-day yield that reflects the interest earned by the fund’s investments minus the fund’s expenses.
• Yield to maturity (YTM): This represents the estimated return of all securities in the fund if held to maturity. YTM is forward-looking and considered more comprehensive than other metrics.
• Yield to worst (YTW): This measures the lowest potential yield that can be received on the bond of bond funds without issuers defaulting on payments. It accounts for bond provisions that allow the issuer to close out the position before maturity and provides a scenario analysis tool.

YTM “is going to be the most useful of all the metrics you’re going to see,” Lazaroff says. “What makes the yield to maturity great is that it’s forward-looking,” unlike other metrics that only tell you about past performance.

If you’re assessing your worst-case scenario when investing, Lazaroff suggests you look for the YTW. “It’s great for scenario analysis that you can do easily on your own because it’s measuring the lowest potential yield that can be received from the bond fund without issuers defaulting,” he says.

Key Differences Between Equity and Income Funds

While, as Lazaroff notes, it’s truer every day that investors are putting their money into funds with many gradations between those simply in equities and those in bonds, it’s helpful to set out their major differences.

Tax Implications of Equity vs. Income Funds

Lazaroff says investors should review how equity and income funds might be treated on their taxes, which can make a major difference in how they invest.

Equity funds: Since equity funds are primarily invested in stocks, they are subject to capital gains taxes. When an equity fund sells a stock at a profit, it’s passed on to investors as capital gains distributions. These are taxed at the long-term capital gains rate if the stock is held for more than a year, which is generally lower than the ordinary income tax rate you pay annually. However, if the stock was held for a shorter period, the gains are considered short-term and are taxed at the investor’s ordinary income tax rate. Dividends passed on to investors are taxed at the qualified dividend rate, usually lower than the ordinary income tax rate.

Income funds: Meanwhile, the interest income generated by bonds is typically taxed at the investor’s ordinary income tax rate. Nevertheless, certain types of bonds, such as municipal bonds, may offer tax-exempt interest income, making them attractive for investors in higher tax brackets. As such, there could be a big difference between one bond income fund and another. In addition to interest income, income funds can also generate capital gains from the sale of bonds, which are taxed like sales in equity funds, and the rate again depends on the holding period.

The Bottom Line

Equity and income funds cater to different investment goals and risk tolerances. Equity funds invest in publicly traded corporation shares and are more suitable for investors seeking capital appreciation and willing to accept higher risk. Income funds hold fixed-income securities like bonds and are often more appropriate for investors prioritizing regular income and capital preservation.

Lazaroff suggests reviewing potential total returns for either kind of fund rather than just looking at dividends or interest income. “A dollar is a dollar, no matter where it comes from,” he says.

Most importantly, ensure that any investment meets your financial goals, risk tolerance, and investment horizon.