The Financial Services sector uses lots of jargon, so here’s a useful glossary of common financial terms.
The return that an investment produces over a certain period of time. If a stock is bought from £1 and sold for £1.33 it has an absolute return of 33%. Unlike relative return, absolute return does not compare and investment’s returns to a benchmark or similar investments. Absolute return funds aim to generate positive returns in all market conditions by using alternative investment strategies outside of those by mutual funds such as short selling, arbitrage, derivatives and leverage.
AIM (Alternative Investment Market)
The Alternative Investment Market is the London Stock Exchange’s international junior market with more than 1,000 listed companies. Launched in 1995, it offers a cheaper and more flexible alternative to the main market for small and high growth companies looking to raise capital and establish a market value for their shares.
An item of property such as a house, savings account or share that has a monetary value. In investment terms the main asset classes are shares (equities), bonds (fixed income securities), cash and property.
A means of diversifying an investment portfolio by dividing the available funds between different asset classes such as bonds, stocks, cash and commercial property. This helps to lower an investor’s risk exposure as a poor performance in one asset class may be offset by strong returns in another. Fund managers follow a range of strategies and invest in different securities, sectors and geographical regions depending on their own investment goals and risk tolerance. They may use fundamental, technical or macroeconomic analysis to help them determine where to invest their funds.
Asset backed securities
A bond which uses assets as collateral. The assets such as loans, leases, a company’s receivables or royalties, but not real estate or mortgages, are packaged together and sold off to the bond issuer. The return of these asset-backed securities comes from customers’ repayments on the underlying assets but this also means that the risk of default on the underlying assets is transferred to the creditors of the ABS. Unlike traditional bonds, asset backed securities are rated on the creditworthiness of the underlying assets rather than the issuer.
A type of insurance which pays out compensation for a future event which will definitely happen, usually death. In contrast, insurance covers an event which may happen. A life assurance policy covers the policyholder for a set number of years and pays out if they die within this time. However, if they are still alive when the term expires, the money is lost.
A bear market is when the price of investments and investor confidence levels fall significantly over a prolonged period. This is generally accepted to be a drop of at least 20% over at least two months and usually happens in a recession. During this time many investors believe the markets will continue to fall and sell their investments, therefore worsening the decline. The term, which is believed to come from stock trading in the 18th century, can apply to whole stock markets or individual securities. It is the opposite of a bull market.
A standard or yardstick against which investment performance is measured. Investors can use these to gauge how well different sectors and individual securities are faring. The FTSE 100 is the most widely followed benchmark index in the UK for large company stocks. Funds may be benchmarked against a specific stock market index or a sector comprising a mix of assets.
One of the most commonly (mis)used terms in finance:
- A debt security issued by a financial institution, government or other organisation for a fixed term period. At the end of the term bond issuers repay the initial money loaned and most make interest payments. Unlike equities, bondholders do not have any claim to ownership of the company which issues the bond. However, as creditors, bondholders have a greater chance of recovering their money from a bankrupt company. Bonds are graded according to their risk with government bonds generally considered to be the safest and can be traded on exchanges.
- Building Society Bond or Fixed Rate Bond: A fixed term deposit account offered by banks or building societies offering a fixed rate of interest for a fixed period.
Life Assurance bond: A single premium whole life assurance used for investment purposes that may be for a fixed term but more commonly open-ended (i.e. no fixed term). Due to tax laws they are a common form of investment in the UK and some offshore centres.
A bull market is when the price of investments and investor confidence levels rise significantly over a prolonged period. This can be due to an economic recovery or boom with stock markets or individual securities making gains often of 20% or more within months. Investors expect that prices will continue to rise and they therefore buy more securities. This is the opposite of a bear market.
The difference between the purchase and sale price of an assetwhen it rises in value over time. Capital gains accrued before the asset is sold are often called “unrealised capital gains”. Most investments including shares, funds and property are liable for capital gains tax if they have increased in value above a government set threshold when they are sold unless they are held within a tax wrapper. Conversely, a capital loss is when an asset drops in value.
This is a term used to describe the aim of most of our investment funds. It simply means the increase in the value of an investment fund.
By ‘cash’ we mean money held on deposit in building societies or bank accounts, where it attracts interest, rather than being invested in other financial products such as equities or bonds.
This can include tradeable instruments such as certificates of deposit and marketable securities, such as government bonds and banker’s acceptances.
In general, the rate at which customers leave a service over a given period. In investment terms this refers to excessive trading in a portfolio to increase the amount of commission paid to the broker at the expense of the investor’s profits. This is illegal in the UK and many other countries.
Consumer Price Index (CPI)
The Consumer Price Index is the main indication of inflation in the UK. It measures the change in a fixed basket of goods and services including food, energy and transportation which are intended to reflect the shopping habits of a typical British family. However, unlike the Retail Prices Index it does not include mortgage costs.
An assessment of the ability of a company, government or individual to repay their debts in full and on time. The better the credit rating, the lower the likelihood of a debt default and the easier and cheaper it is to borrow money. Credit ratings agencies grade debt issuing companies and countries from the highest standard of AAA down to D, indicating that the debt issuer has already defaulted. Individuals are also rated by credit reference agencies with county court judgements, missed payments, bankruptcy orders and excessive applications for credit products all leaving a black mark on a credit file.
A prolonged decrease in the prices for goods and services which can be caused by adverse economic conditions. Significant deflation leads to weak consumer demand, reduced company revenue, lower production levels and higher unemployment. These can create a downward spiral which can lead to a depression if efforts to stimulate the economy fail. Deflation is the opposite of inflation.
The fall in the buying power of money over time usually caused by inflation, or a reduction in value of an asset through wear and tear or lower demand for the item, or rising prices which reduce the value of the asset in the current market.
A prolonged and severe recession in which economic activity slows dramatically, unemployment rises significantly, credit dries up and confidence levels and investment plummet. In a depressed market, the supply of goods exceeds demand leading to falling prices and a depressed and volatile stock market. The consequences of depressions are also widespread business failures, shortage of banking liquidity (a credit crunch) and banking failures, and can even lead to governments defaulting on their bonds.
A financial contract between two or more parties which gets its value from another underlying asset such as bonds, commodities or currencies. These are usually used in hedging strategies to reduce risk levels in other financial transactions although they can also be used for speculation in the hope of achieving big profits in a short space of time. Listed derivatives can be traded on exchanges while others are bought and sold in private transactions. Common derivatives include options, futures contracts and swaps.
A strategy to minimise risk within an investment portfolio by choosing a variety of investments for which the returns are not directly correlated (aligned). Diversification can occur between assets of the same type, such as choosing stocks from companies in different industries, or between asset classes such as stocks, bonds and commodities, or by investing in different geographical regions. This can help smooth out the effects of poorly performing elements within a portfolio although conversely it will also reduce the potential for growth.
The efficient frontier is the basis for Modern Portfolio Theory developed by Harry Markowitz. It is represented by a curved line on a risk/reward graph showing the combinations of different securities which produce the maximum expected return for a given level of risk. The optimal portfolios lie on the efficient frontier. In contrast, portfolios plotted underneath the curve are not efficient as investors would be able to get a greater return for the same level of risk.
Financial markets within developing countries which are actively growing their economy and rapidly industrialising. These have the same physical features of developed markets such as banks and a stock exchange but may have lower levels of regulation and accounting standards. As these tend to have higher economic growth rates, they therefore generate higher returns than developed markets such Europe or the US. However, they are also higher risk due to factors such as political instability, corruption and currency volatility.
A security such as a share that gives an ownership interest in a company. In an investment portfolio, equity is one of the main asset classes along with bonds and cash. Equities in public companies are listed and traded on a stock market, whereas equities in private companies have no readily available market and therefore may be difficult to value or buy and sell.
Exchange Traded Fund (ETF)
An exchange traded fund (ETF) is an investment designed to track the movements of an index, such as the FTSE 100 or the price of Gold. This is done either by holding the underlying stock or using derivatives to achieve the same returns. ETFs are traded on stock exchanges and their price therefore fluctuates depending on the underling index. Like shares, they can be shorted or held as a diversifier within an investment portfolio. ETFs are bought through a broker who will charge a commission but in general they have very low fees as they are not actively managed by an investment professional.
An investment strategy which uses an individual’s moral or ethical principles as the basis for investment decisions. Investors may choose to put their money into companies which have a positive impact on society or the environment. Equally, they may choose to specifically avoid areas such as gambling or companies involved in the arms trade. Ethical funds may screen the stocks they invest in using positive criteria, negative criteria or engagement – when the fund manager tries to use their power as a shareholder to influence the company for the greater good.
Financial Conduct Authority (FCA)
Formerly known as the Financial Services Authority, the FCA is the independent regulator of the financial services industry in the UK. It aims to strengthen market confidence, maintain financial stability, ensure consumer protection and reduce financial crime.
Fund managers look after investment funds for our customers. They create portfolios, buy and sell assets and monitor the performance of the investment funds they manage.
Fund managers look after investment funds for our customers. They create portfolios, buy and sell assets and monitor the performance of the investment funds they manage.
Fund of funds
A professionally managed fund which invests in a variety of other funds rather than directly in securities. There are different types of these collective investment schemes including mutual fund FoF, hedge fund FoF, private equity fund FoF and investment trust FoF. Fund of funds allow for much greater diversification within the portfolio although investors can inadvertently end up with larger than anticipated exposure to a certain stock if it is held within several of the underlying funds. Management fees are higher than on traditional funds as they also include the fees charged by the underlying funds.
A fixed income or index-linked bond issued by the UK government considered to be one of the safest forms of investment. The purchaser loans money to the UK government on the promise that the face value of the bond will be repaid on a set date in the future and regular interest payments (known as the Coupon) will be made up to that date. Gilts have varying long term maturity dates and are traded on the London Stock Exchange. Gilts were originally issued to fund wars (War Bonds) but are now one of the government’s main sources of funding on the international markets. The name dates from when the paper certificates for these government bonds had gilded edges.
Index-linked gilts or index-linked securities are bonds issued by the UK Government that pay regular interest payments, which rise and fall in line with the Retail Prices Index.
See also Gilts. Government Bonds are usually used distinguish debt issued by foreign governments. Although deemed a low risk investment, they are not entirely risk free as a political or economic crisis can still lead the government to default on its debt payments as Argentina did in 2002 and Russia in 1998.
An investment strategy to offset the risk of unfavourable price movements in another investment. An investor buying shares could also sell a futures contract as insurance against a large drop in the share’s price. Investment managers often use this strategy when they are unsure which way the market will go, or to offset the risk of exchange rate fluctuations on profits made overseas.
Net Asset Value (NAV)
The NAV (Net Asset Value) is the market value of the assets that the fund holds. This may be more or less than the fund price, depending on how the market views the fund’s likely growth prospects and the wider economic situation (i.e. what is known as investor sentiment). Sometimes investors are willing to pay over NAV if sentiment is positive, other times funds can trade at a discount to NAV because of poor market conditions or sentiment.
P/E (Price Earnings) Ratio
A valuation ratio of a company’s current share price compared to its per-share earnings. As earnings tend to fluctuate throughout the year for some companies longer term Cyclically Adjusted P/E (CAPE) may be used to look at the longer term trends say over 10 years.
The P/E is sometimes referred to as the “multiple”, because it shows how much investors are willing to pay per £ of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay £20 for £1 of current earnings.
A portfolio is a collection of securities held in a structured (designed) way, rather than a random collection, designed to achieve a specific objective. It might contain a range of assets (see Asset above) or just contain one type of asset such as shares (equities) or property.
A term for an instrument which represents ownership of assets e.g. stocks and shares, or ownership of debt (a bond or gilt), or the rights to future ownership of an asset (derivatives).
In the UK, stocks can mean both shares and Government bonds. Many years ago, stocks meant UK Government bonds only, hence the phrase ‘stocks and shares’. In the US, shares are widely known as stocks. Some UK-based fund management offices use the US terminology.
Total Expense Ratio
The cost of owning units in a mutual fund. The expense ratio is a measure of how much of a fund’s assets it takes to manage and operate the fund expressed as a percentage. This includes all administrative expenses to buy and sell the underlying stocks, the costs of marketing the fund and the management fees going to the fund manager. Actively managed funds tend to have expense ratios of 1.5% to 2% dropping to around 0.15% for index funds.
This is also known as the Ongoing Charge Figure (OCF).
Each fund is made up of units. Units are your notional share of the investment fund. Unit prices rise and fall with the overall value of the investment fund.
Stockmarkets are described as volatile if they move up and down quickly. An asset that has many variations in its price is also described as volatile.
Volatility refers to the amount of uncertainty or risk about the size of changes in a security’s value. A higher volatility means the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.
One measure of the relative volatility of a particular stock to the market is its beta. A beta approximates the overall volatility of a security’s returns against the returns of a relevant benchmark (usually the FTSE-100 is used). For example, a stock with a beta value of 1.1 has historically moved 110% for every 100% move in the benchmark, based on price level. Conversely, a stock with a beta of .9 has historically moved 90% for every 100% move in the underlying index.