Absolute Return (see Hedge Funds)

 

Active Management Fund management where the manager chooses shares on the basis of their perceived attractiveness, as opposed to passive management, where shares are chosen according to their weighting in a given index. See also index trackers

 

Alpha (see Capital Asset Pricing Model (CAP.M)

 

Alternative Assets A phrase which can mean almost anything, but is often used as an umbrella term to describe hedge funds and venture capital investments

 

Annual Bonus (see With-Profits)

 

Annuity An annuity is what happens when you turn a lump sum of money into an income. Annuities are offered by insurance companies.  The income can either be for your lifetime, or for a fixed term of years, in which case it will be called a temporary annuity. Anyone can go to an insurance company and buy an annuity. These contracts are known as purchased life annuities. It is rare for anyone to do so these days, as the annuity rates (see directly below) are so low. Most annuities are bought with the proceeds of a pension fund, in which case they are known as compulsory purchase annuities. Our Guide to Annuities (on the website) explains the different types of annuity you can choose from on retirement, level, index-linked, joint, single, guaranteed, etc.

 

Annuity rate The annuity rate is the conversion factor when you buy an annuity, i.e. when you turn a lump of cash into a lifetime income. For example, if the quoted annuity rate were 6.0%, you would receive an income of £6,000 a year for your £100,000 lump sum. Annuity rates are affected by interest rates and life expectancy. During the last twenty years, annuity rates have fallen steadily. Low interest rates are one explanation, but the other is the extraordinary demographic changes we have seen. Life expectancy across the population as a whole has risen by as much as ten years over the last generation. This change was not anticipated by the insurance companies, and has proved hugely expensive to them. Naturally, they don’t want to be caught out again, so their mortality tables assume that people will continue to live ever longer. So, in the last couple of years, interest rates have risen, but annuity rates have not.  Unless we all live to be a hundred the insurance companies will be ‘quids in.’ Most of our clients realise that annuities are not good value at the moment, and avoid buying them as long as possible.

 

Asset Allocation Research has shown that holding more than one asset class in an investment portfolio can reduce the risk of loss, and can add to the overall return. There are many different approaches. One is to hold ‘core’ assets which are considered to be long-term holdings, with the balance made up by ‘satellite’ holdings which are held tactically.

 

Asset Stripping The process of buying a company, and selling off parts of it for more than the whole company cost to buy.

 

Average Earnings Index (AEI) The most commonly used index of wage inflation in the UK. Wages almost always rise faster than prices (measured by the Retail Price Index or RPI) which is why there was so much controversy a few years ago when the Government decided to increase the Basic State Pension in line with the RPI rather than the AEI a few years ago

 

Bank of England The UK’s central bank. The Bank’s role is to oversee the other banks (known as clearing banks) and to set interest rates in order to hit the Government’s inflation target. (see Inflation)

The Bank of England has been independent of the Government since 1997 

 

Base Rate This is set by the Bank of England, so its full title is the Bank of England Base Rate.  Since 1992 the UK has had an official inflation target. The Bank of England, which has been independent since 1997, has the job of setting interest rates in order to keep inflation within its target. When the economy grows at a faster than sustainable pace, inflation starts to rise, and the cure is to raise interest rates, which deters people from borrowing more money.  When growth is too slow, inflation falls, and the remedy is a cut in interest rates. The Monetary Policy Committee (MPC) of the Bank of England meets once a month to decide on interest rate policy. Each month, following its discussions, the new Base Rate is announced.  The Base rate is so called because it forms the basis which all the other banks (known as Clearing Banks) use to calculate their deposit and borrowing rates.  Normally Clearing Bank lending rates are above the Base Rate, and sometimes banks will quote an interest rate at a fixed level above the Base Rate. Sometimes they use LIBOR instead.

 

Basic State Pension (see State Pension)

 

Basis Point A basis point is one hundredth of one percent. This is often shortened to bp (pronounced ‘bip’) So, when the Bank of England decides to raise interest rates by a quarter of one percent, you may hear people saying that interest rates have gone up by ‘twenty-five bips’.   If so, please feel free to hit them with the nearest heavy object.

 

Benchmark Normally an index against which the performance of a share or fund is measured.

 

Beta - (see Capital Asset Pricing Model (CAP.M)

 

Bid Price (see Unit Trust)

 

Blue Chips Shares of the largest, best known companies.  The term implies quality as well as size.  Often the term ‘blue chip’ is used to refer to the UK’s largest hundred companies, contained in the FTSE-100 index.

 

Bond Probably the most confusing word in the investment dictionary.  The origin of the term is that someone who enters into a bond is bound by it, so the word bond implies a contract.  The word ‘bond’ has two main, and completely separate meanings. The older one refers to any type of fixed interest contract. The more recent one is a particular type of investment contract offered by insurance companies, with its own special rules and tax treatment, known as an Insurance Bond, or sometimes as an Investment Bond.  This terminology can be confusing, because investors in Insurance Bonds can normally invest in a wide variety of areas through a range of funds, of which one option of many will be fixed interest (i.e. bonds)

 

Bubble A term used to describe a situation where investors become so highly enthused by the prospects for a particular asset class that they are prepared to pay far above the intrinsic value.  Bubbles always end in collapse.  The first known bubble was the South Sea Bubble in the early eighteenth Century, followed by the Dutch Tulip mania two decades later, when investors were prepared to pay the equivalent of £100,000 in today’s money for a single tulip bulb.  A more recent example is the TMT (Technology, Media and Telecoms) bubble of the late 1990s, which focused on the commercial possibilities of the Internet.  Investors were prepared to pay huge sums for small stakes in start-up companies such as boo.com, a global sport and fashion retail site which received £130m in investment before going bankrupt in May 2000.  At the height of the bubble, the Nasdaq Composite index of mainly US technology stocks stood just above 5000.  Seven years later, it is still below half that level. Many of the constituents of the index in early 2000 have disappeared.  Three common characteristics of a bubble are novelty - a new idea or asset class (emerging markets, biotechnology, internet) a rapid rise in prices, and the sense that ‘things can only get better’.  Very optimistic projections of future growth are used to justify valuations, with no possible setbacks priced in.

 

Bull Someone who expects the price of a financial asset to rise, and has in many cases invested in it in anticipation.  (S)he holds the opposite view to a bear, who is expecting the same asset to fall in value.  Hence a bull market, one in which share prices are rising, and a bear market, in which they are falling.

The origin of the terms is unclear.

 

Call Option (see Options)

Cap. When a contract contains a cap, it means that something can’t rise above a pre-agreed level. For example, in a capped mortgage, the interest rate you pay will never rise above a level which is written into the contract at the outset. Certain options strategies can cap your gains or losses (see derivatives).

 

Capital Asset Pricing Model (CAP.M) The CAP.M is a system for valuing securities which has gained widespread acceptance in the investment community, and covered in every investment exam syllabus.  It attempts to quantify investment returns and risk. Naturally investors want the maximum return with the minimum risk, and the CAP.M is designed to show how successful different investments are in this regard. Returns for different investments are compared to the Risk-Free Return, normally the return on index-linked government stock.  Risk is measured by Standard Deviation, which is the tendency of returns to fluctuate from one time period to another, i.e. to be more or less predictable.  Two terms have come into common use, Alpha and Beta.

The Alpha of a share or fund is a measure of how much it will tend to move during a period when its benchmark index doesn’t move at all.  The Beta of a share or fund is how far it will tend to move when the benchmark index rises one point.  These concepts are quite difficult, but are worth understanding as they are now in such common use.  A fund which has a tendency to rise when its benchmark index is static is clearly attractive, which is why there is a fashion among investment companies to launch funds with names like ‘XYZ High Alpha’ or ‘Absolute Alpha’  Everyone would like you to think that their fund adds value, i.e. has an Alpha score above one.  Beta, on the other hand, is a measure of volatility, or risk.  A share or fund with a Beta score of more than one is more volatile than its benchmark index, i.e. you can expect it to go up by more than the index when the market is rising, and fall further than the index in a falling market. If it has a score of less than one it is less volatile than the index, and if it has a negative score it has a tendency to move in the opposite direction to the index, as people say its ‘returns are negatively correlated with the index’

The Cap.M is now accepted by many in the investment community.  However, it has one obvious drawback.  The figures it uses are historic, and as we know past performance cannot be taken as a guide to the future.  Yesterday’s stable performer may become volatile next week.

 

Capital Shares (see Split-Capital Investment Trusts)

 

Capital Taxes A phrase used to describe Capital Gains Tax and Inheritance Tax

Carry Trade (see Hedge Funds)

Caveat Emptor Let the buyer beware.  As investors, this one is always worth remembering.  If something you own goes down in value, you know you will lose money. When taking advice, it is worth asking yourself the question, what does this person who is advising me stand to lose if I lose money?  It is a long-term relationship with me, a future income stream, and possibly a local or even national reputation?  Or is it nothing? Is this a one-off deal for which the adviser is going to receive a one-off payment and nothing thereafter?  If the latter, then caveat emptor.

 

Chart Analysis Also known as Technical Analysis.  A system which aims to use historic price data, to predict the future price movements, mainly of shares and commodities. We talk to a lot of fund managers. Many believe that chart analysis is nonsense, and a complete waste of time.  Others including me find it useful. Price charts are a historic record of what investors have done with their money, of the balance of sellers and buyers in the market at different times in the past.  With so much data available, it would be surprising if there were no repeating patterns of behaviour to be seen.  Sentiment swings from pessimistic to optimistic, and quite often goes too far in each direction.  When a price falls repeatedly to a certain level and then each time rises from there, it is a sign that at the low point there are no sellers left, or that they are on each occasion outnumbered by buyers.  This can be an indication that it is safe to buy at that level.

The basis of chart analysis is Dow Theory, which identifies uptrends and downtrends.

This idea is very simple and extremely useful. Prices almost never move in a straight line, but can often move in the same overall direction for months or years at a time. An uptrend is when the overall movement is up, despite minor periodic falls or corrections. In a typical uptrend, each new high point will be higher than the previous one, and each low point will also be higher than the previous one. Trends last longer than most people expect, often for several years, and tend to carry prices further than anyone could have imagined in the early stages of the price movement.  Dow Theory helps us not to book profits too early, by telling us not to worry about the falling price of an asset we hold, so long as the overall trend is up.  The trend remains up so long as at the end of each period of weakness, the price ends up higher than at the end of the previous period of weakness. The trend is confirmed if the ensuing period of strength takes the price to a new high. (People talk of higher lows and higher highs as the characteristics of an uptrend).  If it doesn’t then the trend may be ending, and it is time to take profits.  Dow Theory also helps us not to buy an asset too early, while it is still in a downtrend (each new low is lower than the last one, and each new high is lower than the last one).

Chart analysts watch the moving averages of shares carefully. Moving averages show the smoothed path of a price, with the smaller fluctuations taken out. The moving averages we use most commonly are the twenty-day moving average (the average of the last twenty days’ closing prices), and the two-hundred day moving average (the last two hundred days’closing prices). The point when the short-term (twenty-day) moving average cuts upwards through the longer term (two hundred day) average is known as a ‘golden cross’ and is often the prelude to significant further price rises, because it indicates that investors have continued to buy at higher levels where previously they had started to sell, and is thus a sign of improving sentiment towards a particular market or share.  Conversely, when the short-term average cuts down through the longer-term average it is known as a ‘dead cross’ and can be a prelude to substantial price weakness.

There are a number of well-known chart patterns which predict a change of direction, such as ‘Head and Shoulders’ and ‘Double Top’ (or bottom).  We have found the most reliable one to be the ‘rounded bottom’, which is quite common. It normally takes the shape of a parabolic curve, beginning with a steep fall which gradually abates, flattens out and eventually begins to rise from a low level.  Given that the asset is a good one, and subject to market conditions being stable, it is often safe to buy shares and funds at the point where a ‘rounded bottom’ turns upwards.  Such a move would normally take place over a period of 6-18 months. The pattern normally works because at the end of such a move, only committed investors are left, the others having all given up in despair.  There is at that point no further selling pressure to push the price further down, or as people say there is no ‘downside pressure.’ A rounded bottom pattern can be aborted at any stage, normally if new bad news is received, but is generally reliable.

Possibly the most memorable term used by chart analysts is the ‘dead-cat bounce’, which describes a situation where a feeble rally follows a sudden big fall.  This move indicates that investors aren’t convinced that the share is worth buying even at the lower level, and suggests that there will be no major upwards move any time soon, and that the price may fall further before recovering.

 

Churning is where an adviser repeatedly sells and re-buys shares in a client’s investment portfolio, for the sole purpose of generating commission.  Over the longer term, we have found that the natural rate of turnover in a well-managed portfolio is around 10-15% per annum, though if everything performs well and doesn’t become overvalued there is no reason why it can’t be zero.  We would be suspicious of turnover levels which were consistently higher than these.

 

Closed-ended funds.  Investment trusts are closed-ended, while unit trusts are open-ended. When you buy units in a unit trust, your cheque goes to the manager who invests your money to create new units in the fund. That’s open-ended.  Investment Trust managers don’t routinely create units, so when you want to buy investment trust shares, you have to go out into the market, usually via a stockbroker and find someone who wants to sell you their shares. That’s closed-ended. The difference is that when you invest in an open-ended fund, the manager gets some new money to invest, and when you invest in a closed-ended fund, he doesn’t. In a falling market, it is better to be the manager of a closed-ended fund, who doesn’t have to return money to shareholders.  In that situation the manager of an open-ended fund has to return cash to shareholders who redeem units, and may have to sell some of his favourite shares at a bad time in order to do so. (Why his favourite ones?  Because in a falling market no one is in a hurry to buy shares, and only the very best ones are saleable).

COLL The new rules regulating collective investments (mainly unit trusts and OEICs).

Collective Investments Investment funds in which the savings of a large number of investors are pooled together and managed as a single unit. Insurance funds, unit trusts and OEICs are all collective investments.

 

Commission.   A payment made by an investment company to an intermediary who has introduced the business on behalf of a client. The three main forms of commission are initial commission which is paid upfront on a new investment, trail commission which is paid on existing lump sum holdings in collective investments and renewal commission which is paid in respect of regular premium payments to insurance policies.

The standard rates of commission are - Initial, 3% for units trusts and OEICs, 4.00% on insurance bonds where trail commission is going to be paid, higher if not.  Trail 0.5% per

Annum. Renewal  2.5% of the premium payment.  However, rates vary widely between contracts.  It is important to know what level of commission is being taken from any contract you have entered into, or are about to enter into.

Industry-wide levels of commission have come down steadily over the years but are still high.  Wise Investment’s rates are very low by industry standards.

 

Commission Disclosure Financial advisers are obliged to disclose in cash terms the amount of commission they are due to receive on any insurance or investment contract, before it comes into force.

 

Commodities  ‘Hard’ commodities are metals, e.g. gold, silver, copper and zinc. ‘Soft’ commodities are agricultural, and include wheat, maize, and coffee.  Commodities can be sold either spot or forward.  Spot means for immediate delivery, and forward means for delivery at a pre-agreed time in the future.  Forward prices are affected by supply factors, so if it looks as if the harvest will turn out better than expected, the forward price of the commodity will fall.

 

Compulsory Purchase Annuity (see Annuities)

 

Convertibles A type of fixed-interest investment which is not now nearly as common as a decade ago.  Companies issue a ‘convertible’ stock, which normally pays a higher yield than the ordinary shares, and carries the right to be converted into an ordinary share at a pre-agreed price at a given point (often more than one point) in the future.

 

Cooling-off period A period at the beginning of a new investment contract.  During this time the client has the right to withdraw from the contract free of charges or penalties.

 

Correlation The tendency of the price movements of two different assets to resemble one another. Low correlation means that there is very little similarity in the price movements.  Negative correlation means that they have a tendency to move in opposite directions.

 

Counterparty The person (individual or institution) on the other side of a transaction

 

Creation Price (see unit trusts)

 

Coupon (see fixed interest)

 

Covered Call Option (see Options)

 

Currencies National units of money.  The UK currency is the pound sterling, the US currency is the dollar, etc.

 

Dead-cat bounce (see Chart Analysis)

 

Defensive shares Ones which have a tendency to hold their value in a falling market, (in other words they have a low beta) Traditionally these might be shares in companies whose businesses would not be greatly affected by recession, because their products are in demand at all stages of the economic cycle, e.g. water and electricity companies, food producers, pharmaceutical companies etc.  In practice, different shares exhibit defensive qualities in different investment cycles.

 

Deflation (see Inflation)

 

Deposit A cash account, such as a bank or building society account, is normally known as a deposit account. Deposits are normally either instant access, which allows you to withdraw money without penalty at no notice, and term deposits.

 

Derivatives A huge market has grown in securities which derive their price from shares and bonds and hence are called derivatives.  It is a complex area, and becoming more complex each year.  There is a good deal of technical language, but as Wise Investment avoids the derivatives markets almost entirely, it has little relevance here.  However, it is worth briefly mentioning options, which are the most common form of derivative, and the ones you are most likely meet face-to-face.

There are two main kinds of option, call options and put options. They are mirror-images of each other, so let’s concentrate on call options.  Let’s say the price of Barclays Bank shares is £7.00 and today is January 3^rd. I can buy an option to purchase a thousand shares in Barclays Bank at £7.50 each between now and the end of March, when the option will expire. In other words, I have bought the March £7.50 calls in Barclays Bank.

Let’s say the cost is £100. The call is out of the money, in other words it is worthless, because an option to buy something for £7.50 that I can buy for £7.00 in the market isn’t worth having.  But I buy the calls because I strongly suspect that the price of Barclays shares is going to rise, in other words I am a bull of the stock. And, I turn out to be right. By March 20^th the shares have risen to £8.00 each. My option is now in the money. It is worth a thousand times 50p, or £500, because it allows me to buy a thousand shares for 50p less than each one is worth.  So my original £100 has become £500.  I have made a return of 400% as a result of a move of just 14% in the price of the underlying asset.  However, the trade is a speculative one, and if the option had expired out of the money, which it would have done if the share price had failed to reach £7.50 during the option period, then I would have lost the whole of my option premium of £100.

Sometimes options are used for portfolio insurance.  One simple strategy would be to buy put options in shares you hold in your investment portfolio.  The puts would rise in value in a falling market, and offset losses on the underlying shares.  This is not a strategy that Wise Investment has ever recommended.

Another strategy is to write i.e. issue covered calls.  This strategy is a secure way to increase income from an investment portfolio, and is one we might recommend if the situation was right for it, through funds rather than actually writing the calls personally.

The way this works is fairly simple. Let’s say I own a thousand Barclays shares in my investment portfolio, it’s January 3^rd and they are £ 7.00 each. I write a contract for a thousand calls at £ 7.50, and sell it to someone for £ 100. This £ 100 is income, and I can spend it.  Most likely the option will expire worthless, so that is the end of the transaction, but if the share price rises above £ 7.50, then I will sell the shares, keep £7.50 per share, and pay the difference over to the counterparty.  In other words, the effect of writing covered calls is that it increases your portfolio income, but caps your potential for capital gains. If you feel that the trade-off works well for you, then it is worth looking into further, and there are funds, such as the Schroder Income Maximiser, which use this strategy.

Before leaving the subject of derivatives, it is worth mentioning credit default swaps, which is a rapidly-expanding area of the fixed-interest derivatives market.  Some fixed interest fund managers think that credit default swaps are a wonderful tool for managing risk, while other commentators see the area as a disaster waiting to happen.  As is our normal practice, Wise Investment is avoiding the area for the time being, until the market has matured, and we can be more sure what the benefits are for our clients, and whether they outweigh the risks, costs and complexities.

 

Discount (see Investment Trusts)

 

Dividend The income payment companies make to shareholders. The dividend is not the same as the profit. Some companies make profits but don’t pay dividends, preferring to use the profits to help the company grow. Some companies make a dividend payment which is higher than their profit, or when they have made a loss. This is known as an uncovered dividend.  Such a situation normally occurs when a company has had a bad year, and wants to reassure shareholders that they are confident things will improve. An uncovered dividend can’t be sustained for long, or the company would run out of cash.

However, the most common situation is where a company pays out a proportion of its profits as a dividend. The dividend cover in any year is the number of times the company could pay its dividend out of that year’s profits. So, if a company makes a profit of £4 million and pays £2 million as a dividend, the dividend cover is two times.  If it only pays £1 million, the dividend cover becomes four times. As investors, when investing for income, we like to see dividend cover of at least two times. Any number significantly lower may not be sustainable in the longer term.

Most UK companies pay an interim dividend and a final dividend.  The interim dividend is normally paid around six weeks after the publication of the half-year accounts, and the final dividend around three months after the publication of the full year accounts, the longer delay being due to the stricter accounting requirements at the full-year stage.  Most companies’ final dividend is bigger than the interim payment - a ratio of around two to one is common.

Most UK companies have 31^st December as their year-end date, and the majority of those that don’t, use March 31^st.  Thus the dividend payment year is ‘lumpy’, with a lot of hefty final dividend payments in June and July, and very little coming in between the middle of October and Christmas.

 

Dividend Cover (see  Dividends)

 

Dividend Reinvestment Many income-paying shares and funds offer investors the choice of giving up the dividend payment in exchange for an equivalent value of new shares. For investors who like the asset, but don’t need the income, this arrangement can work well.