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Glossary

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Alpha

Alpha is a measure of a fund’s over or under performance compared to its benchmark.  It represents the return of the fund when the benchmark is assumed to have a return of zero.  It shows the extra value that the manager’s activities seem to have contributed.  If the Alpha is 5, the fund has outperformed its benchmark by 5% and the greater the Alpha, the greater the out performance.

 

Beta

Beta is a measure of a fund’s volatility compared to its benchmark, or how sensitive it is to market movements.

A fund with a Beta close to 1 means that the fund will move generally in line with the benchmark.  Higher than 1 and the fund is more volatile than the benchmark, so that with a Beta of 1.5, say, the fund will be expected to rise or fall 1.5 points for every 1 point of benchmark movement.

If this Beta is an advantage in a rising market – a 15% gain for every 10% rise in the benchmark –the reverse is true when markets fall.  This is when managers will look for Betas below 1, so that in a down market the fund will not perform as badly as its benchmark.

Child Trust Fund

A Child Trust Fund is a savings and investment account for children. Children born on or after 1st September 2002 will receive a £250 voucher to start their account. The account belongs to the child and can’t be touched until they turn 18, so that children have some money behind them to start their adult life.

Payments or contributions can be made up to a maximum of £1,200 per 12 month period (starting on the birthday of the child), excluding the voucher amount. Interest and capital growth will be earned tax-free. Additional deposits can be made by parents, grandparents or anyone else.

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Fixed Interest

The term fixed interest is often used by banks and building societies relating to an account that pays a set rate of interest for a set time period.  This type of investment is capital secure and the returns are known at outset.

However, fixed interest within the investment world is a completely different concept.  It is used to describe funds that invest in Government Gilts and Corporate Bond securities.

Gilts
 
Gilts are effectively Government borrowing.  When the Chancellor does not have sufficient income to meet his expenditure, then the Government will often borrow money in the form of gilts.  These can be for a variety of different terms, paying a range of interest rates.
 
A typical example would be a ten year gilt which may pay, say, 5% income.  This is the most secure investment you could buy, as you know the rate of return and you know when you will receive your capital back.  The UK Government has never defaulted on a gilt.
 
If however you wanted to access your money before maturity then you would have to sell your gilt on the open market.
 
Let’s say you were trying to sell your gilt after one year.  In order to obtain a value any potential purchaser will look at the term remaining on your gilt and the interest rate promised, and compare this to new gilts being launched at the time.  If the Government was then launching a new gilt over a nine year time period, and promising to pay 6% per annum, then clearly nobody is going to want to pay the same amount of money for your gilt which is offering a lower interest rate.
 
They would probably therefore offer at least 9% less than you originally paid for it to reflect the 1% difference in income over the nine years of the remaining term.
 
So whilst you had set out to achieve guaranteed returns, if you sell a gilt before maturity you could potentially make a capital loss on it, in this instance a loss of 9% over the year.
 
However, if you decide to keep the gilt until its maturity you will still receive all of your interest and the capital back.  Having said this, your valuation each year will vary depending on market conditions

Corporate Bonds

Corporate Bonds are similar to gilts but are a form of borrowing by companies rather than Governments.
 
Let’s say Astra Zeneca wished to borrow a billion pounds for research and development.  They would initially approach their brokers who would review the strength of Astra Zeneca versus the Government to assess what is a reasonable “risk premium”.
 
A secure company might be able to borrow money at 1 or 2 percentage points above the gilt rate and a very insecure company may have to pay 10 percentage points above the Government rate or in some cases substantially more.
 
Companies’ security is generally graded from AAA to no rating, the less secure debt being known in the UK as “High Yield”, or as it is more accurately described by Americans as “Junk Bonds”.
 
So with Corporate Bonds the short term returns will vary in line with interest rates as they do with gilts, but also in line with the perceived strength of the company.

Investment Bond


An investment bond is defined as 'a single premium life assurance policy for the purposes of investment.'

To understand this better, consider each element of this definition: 'Single premium' means that a lump sum investment is made at the beginning of the life of the policy. Should you die whilst your bond is in existence the amount you originally invested (minus and withdrawals you have subsequently made) would be paid out to your estate, (or to your nominated beneficiaries if the bond is in trust). Hence bonds are a form of 'life insurance'.

The money you put into a bond is invested by the insurance company and is expected to make some form  of growth throughout its life. As such they are an accepted form of 'collective investment' (see separate handout on 'Collective Investments'). A bond is typically a medium to long term investment.

For taxation purposes any growth within a bond is treated by the HMRC as 'income' rather than as an increase in the capital value. Internally (i.e. at the level where the money is invested by the insurance company) any gains made are taxed at the basic rate of income tax.

The bond holder is able to make annual withdrawals from the policy of up to 5% of the invested amount without any immediate tax to pay. They are actually assessed for tax when the policy matures or is encashed which is often 20 years after it is taken out if held to maturity.

Pension Fund Withdrawal

Also known as “income drawdown”, this is the process of taking income directly from a pension fund, as opposed to the alternative of buying an annuity. The government sets maximum limits on the amount of income taken, and your pension fund will need to continue to grow to offset the amount of income you wish to take.  The level of growth rate you need to achieve to keep your income above a certain level is known as the “critical yield”.

Risk

Stock-specific risk

This is the risk that there might be a reduction in the expected return as a result of some event or circumstance specific to a company, e.g. the fortunes of Glaxo in the ‘80s and ‘90s were linked to the success of drugs such as Zantac. 
 
Market risk

The risk that there might be a reduction in expected return as a result of a fall in the stock market generally, e.g. virtually all shares on the Stock Exchange fell in the great bear market of 1973 - 74 and, to a lesser extent, in the crash of 1987 and the bear market of 2000 - 03.

Currency risk

Where investment is overseas sterling may appreciate against the investing currency. During 2004 sterling rose against the US dollar, almost completely eliminating the capital growth from investments in US equities.
 
Geographic risk

A major ‘Act of God’ can have a disastrous affect on the performance of a country’s businesses or an industry. Economic losses from natural disasters were greater in the 1990s than in the previous four decades combined. In 1998 alone storms, floods, droughts and fires caused almost $100 billion in economic losses1, equivalent to the entire GDP of New Zealand2!

1. Source: http://www.worldwatch.org/press/news/1998/11/27
2. Source: http://www.cia.gov/cia/publications/factbook/rankorder/2001rank.html
 
Political risk

A change to a government with different fiscal and monetary objectives: this may be as a result of the democratic process or it may occur through coup or revolution. For example, part of the UK market’s decline in 1973 - 74 was attributed to the election of a Labour government that was perceived in some quarters as left-wing. The political risk of investing in China is far greater than investing in the UK as the
Chinese economy is subject to the unpredictable whims of the Chinese government.
 
Interest Rate Risk

Rate rises lead to falls in fixed interest securities values and returns from variable rate cash accounts.

Re-investment Risk

When income received during the life of the investment cannot be re-invested at the predicted rate.

Business Risk

The management of a company makes poor business decisions or a whole industry may go into decline.

Default Risk

When the issuer of a bond fails to pay the interest or repay the capital.

Inflation Risk

The real value of the investment and the income from it falls because of inflation.

Liquidity Risk

The investment may be difficult to sell or encash.

Sharpe Ratio

This is a commonly-used measure which calculates the level of a fund’s return over and above the return of a notional risk-free investment, such as cash or Government bonds. The difference in returns is then divided by the fund’s standard deviation – its volatility, or risk measurement. The resulting ratio is an indication of the amount of excess return generated per unit of risk.

Tracking Error

This statistic measures the standard deviation of a fund’s excess returns over the returns of an index or benchmark portfolio. As such, it can be an indication of ‘riskiness’ in the manager’s investment style. A Tracking Error below 2 suggests a passive approach, with a close fit between the fund and its benchmark. At 3 and above the correlation is progressively looser: the manager will be deploying a more active investment style, and taking bigger positions away from the benchmark’s composition.

Volatility

Standard deviation is a statistical measurement which, when applied to an investment fund, expresses its volatility, or risk. It shows how widely a range of returns varied from the fund’s average return over a particular period. Low volatility reduces the risk of buying into an investment in the upper range of its deviation cycle, then seeing its value head towards the lower extreme. For example, if a fund had an average return of 5%, and its volatility was 15, this would mean that the range of its returns over the period had swung between +20% and -10%. Another fund with the same average return and 5% volatility would return between 10% and nothing, but there would at least be no loss.


 

 Equilibrium Asset Management (A Limited Liability Partnership) is authorised and regulated by the Financial Conduct Authority. For more information, please go to www.fca.org.uk.