A fund that uses a skilled fund manager, a strategy, or a quantitative algorithm to try and generate returns above some index which is its benchmark. In return for the promise of higher returns the fees of active funds are generally higher than passive funds which try to match the returns of a benchmark, not beat them.
A loan that can be traded and which is repaid at the maturity of the bond. The upside on bonds is limited which is why bonds are sometimes called “fixed income”. A bond has a finite life and ultimately you will get your money back, unlike a share which never matures. The entity borrowing money by issuing the bond is called the issuer, this can be a government (government bond), or a company (corporate bond). Bond owners receive periodic payments called coupons and this income is what draws investors to the asset class.
Bond payments must always be repaid, unlike dividends on shares. If a coupon payment is missed this is called a default and it can lead to bankruptcy of the company. Credit rating agencies such as Moody’s, Standard and Poors and Fitch are paid by issuers to rate their bonds according to their risk of default. Investors can either buy bonds on their day of issue, which is called buying in the primary market, or from another investor after the bond issued in the secondary market. The secondary market can be very illiquid for some corporate bonds, which means that it can be difficult and time-consuming to find a buyer or seller for a bond. PensionCraft offer a step by step course all about Everything You Need to Know About Bond Funds suitable for beginners.
A way of raising money for a company by issuing debt. This is risky for the company and the buyer of the debt because if the company misses a single coupon payment it triggers default and may lead to bankruptcy. In the event of bankruptcy bondholders are repaid before shareholders which is why bonds for a given company are less risky than the shares of that company. Some bonds are “rated” by credit rating agencies where they are given a letter signifying the risk of owning that bond. Ratings are linked to the probability of default with the dodgiest companies’ debt classified as junk (sub investment grade) and the most financially sound companies classified as investment grade.
The largest corporate bond market is in the US ($15 trillion financial company debt, $6 trillion non-financial) with much smaller markets in Japan ($2.7 trillion financial and $750 billion non-financial) and Europe (UK $2.7 trillion financial, $570 billion non-financial, France $1.5 trillion financial, $640 billion non-financial).
Central banks have multiple roles that vary between countries but maintaining financial stability is common to all of them. That means keeping inflation in check by setting interest rates, also called their interest rate policy. The most influential central bank is the US Federal Reserve (the Fed) where rate policy is set by the Federal Open Market Committee (FOMC). The minutes of their committee meetings are published and pored over by analysts all over the world because US interest rates are a prime mover of all global markets.
The mandate for the Fed is two-fold: maximizing employment and stabilizing prices (inflation). Next most influential is the European Central Bank whose mandate is to maintain inflation at or just below 2%. In the UK we have the Bank of England (BoE) and Japan has the Bank of Japan (BoJ). Several central banks also have a duty to regulate the banking system and to control the creation of physical currency.
When a government or a company borrows money by issuing a bond there is a risk that they will not be able to repay the bond. If they miss a single coupon payment they trigger an event called default. Ratings agencies grew out of the local government bond market in the US in the 1800s where there were many debt crises as states issued too much debt, often to build railroads, and then defaulted on that debt. By looking at a borrower’s net income, debt level and assets the ratings agencies classify the quality of their debt according to their ability to repay.
Debt which is less likely to be repaid will compensate investors by offering a higher income, and as a result the rating received by a company or a country directly affects its cost of borrowing. The largest ratings agencies are Moody’s, Standard and Poors and Fitch. The entity issuing a bond pays to have its debt rated, which can lead to a conflict of interest as the agencies may compete to provide the highest rating. The rating is a letter code, as shown below. Ratings are dynamic, and as the financial wellbeing of a company or country wax and wane the rating will change to reflect their ability to repay their debt.
After a stock falls sharply because of bad news it sometimes seems to rally over the next few days. This is not the market realizing it has made a mistake and re-pricing to a higher level, it is a temporary rise often due to short covering.
When you retire and start to take money out of your pension savings the rate at which you do so is called the drawdown rate. The best drawdown rate is difficult to judge, and rather morbid to calculate, because you have to estimate how long you will survive. For example if you have £1 million in your savings, retire at 65 and expect to live another 25 years to the age of 90, then if you withdraw 4% each year that will give you £40,000 each year. A rough rule of thumb is therefore that you can withdraw 4% of your money each year. If you are lucky the pot will grow in line with inflation as you draw down, if you are unlucky it won’t.
This simple 4%-per-year approach may run into problems and could leave you with no money before you die if your investments suffer during a market crash or if you live longer than expected or if inflation spikes due to economic mismanagement by the government. That’s why it is best to draw down only what you need, and if that is below 4% so much the better.
This risk measure looks back over some period of time, often a year, and measures the largest peak-to-trough fall of an asset’s price. For example if a share reached a price of £100 over the last year but subsequently fell to £50 on bad news its drawdown would be 50%. This is a very pessimistic risk measure because it always focusses on the worst event whereas volatility looks at typical or average price movements. See our comparison of risk measures in “What is the best way to measure risk?“.
An ETF is a fund traded on a stock exchange just like a share. The benefit of being exchange traded is that the fund is extremely liquid. This means that the fund can be bought or sold very quickly while markets are open, and it also means the fund is priced continually during the day so its value is always known. Because it is a fund an ETF can contain any asset class: shares, bonds, commodities, volatility or even multiple asset classes. Almost all ETFs are passive funds whose goal is simply to match an index such as the FTSE 100 or the S&P 500 and to do so as cheaply as possible. The return of a tracker fund and the return of the index it is tracking should ideally be identical. In practice the two are different and this difference is called tracking error.
If government spends more than it earns it has to plug the gap by borrowing money, so it issues bonds. These must be repaid, but the risk of default is very low for developed economies that can print their own money. The largest government bond market is the US ($16 trillion in Q3 2016) followed by Japan ($11 trillion) with developed European countries trailing far behind (UK $2.7 trillion, France $2.1 trillion, Italy $2.1 trillion, Germany $1.8 trillion, Spain $1.1 trillion).
For emerging market economies defaults are much more likely, so they pay a higher yield than developed market government bonds and this extra yield is to compensate investors for their higher default risk. Some emerging market countries issue debt in dollars which can lead to crises if the dollar strengthens as this increases both the level of their debt and their regular coupon payments.
This is the modern day version of the Domesday Book. UK GDP is the total value, in pounds and pence, of all goods and services produced over the course of a year in the UK and is currently around £2 trillion per year. It is measured by the Office for National Statistics and published four times a year, although this is split up into a preliminary, second and final estimate as more data becomes available. People usually talk about percent changes in GDP rather than the amount in pounds because it is growth that matters. Inflation is usually subtracted from GDP i.e. people talk about real GDP. In some cases inflation is not subtracted in which case this is nominal GDP.
If growth turns negative for several quarters in succession this is called a recession and is bad news for companies, whose earnings typically fall as economic activity slows down, and workers whose jobs become more precarious as companies lay off staff to cut costs. The purpose of measuring an economy’s GDP is primarily so the government can see how much tax it can raise. In fact the disciplines of statistics and economics owe their existence in large part to measurement of Gross Domestic Product. For investors GDP is not as useful as Purchasing Manager Indices because it is backward looking. Equity markets usually sell off far in advance of a formal recession.
Economic data that is based on production and earnings rather than sentiment. For example hard data would include Gross Domestic Product, industrial production, inflation, wage growth and corporate earnings. This is objective, hard facts based on things which can be measured rather than opinions about the future gathered in surveys which are sometimes described as soft data.
An index combines the prices of many assets in a market to produce a single number summarising that market’s performance. For example the S&P 500 stock index measures the prices of 500 of the largest US companies and provides a general reading on the performance of US stocks. News media often report the prices of stock indices as a sort of shorthand for how markets are performing. It is now possible to buy a whole market with very low fees though passive exchange-traded funds.
The cost of living tends to increase over time. This is usually measured by the same national statistical agencies that measure economic growth (e.g. the Office for National Statistics in the UK). Inflation is measured by regularly surveying the cost for a typical basket of goods consumed by people in a country. This “consumption basket” changes over time as fashions change e.g. duvets, Cinzano, VHS recorders and muesli in the 1980s, fromage frais and CD players in the 1990s, chicken nuggets, MP3 players, satnav and Freeview boxes in the 2000s and garlic bread, tablets, microwave rice, coffee pods and computer game downloads in the 2010s. But the ONS builds a price index which combines all these prices into one number.
The index, known as the Consumer Price Index (CPI) rises as the cost of goods in the consumption basket rises. Inflation linked bonds have their repayment amount and coupon payments linked directly to inflation indices. Investors buy inflation linked bonds them to provide protection against the rising cost of living. Shares tend to fall in value when inflation becomes too high (above 4% per year) or too low (below 1% per year). If the cost of living is falling this is called deflation and if the rate of change of inflation is slowing this is called disinflation. Central banks usually try and steer inflation to be around 2% by setting the level of interest rates: if inflation is below target they raise rates, if it is too low they lower rates.
The time taken to buy and sell an asset. This can range from milliseconds to years. Generally the rough ranking of liquidity would be: currency markets and shares tend to be most liquid, then developed market government bonds, then investment grade corporate bonds, then high yield bonds, then property. Low liquidity drives up the cost of trading, increasing the difference between buying and selling prices. In markets where there are exchanges and market makers liquidity is highest.
The total value of a company on the stock market, usually abbreviated to “market cap”. This is the number of shares issued by the company multiplied by the price per share. For example if a company has a million shares each worth £10 then its market capitalisation would be £10 million. Market capitalisation is affected by the share price, so if the share price increased to £20 the market cap would increase to £20 million. People talk about “large cap” and “small cap” companies and there are usually stock indices which focus on stocks grouped by their market cap.
For example in the UK we have the FTSE 100, which is the largest 100 companies by market cap listed on the London Stock Exchange, the FTSE 250, which is the next 250 largest and the FTSE SmallCap which is the 351th to 619th largest companies by market cap. Companies with a smaller market cap tend to be more expensive to trade i.e. they have a bigger bid-offer spread and they have lower liquidity. Most stock indices are weighted by market cap, so larger companies make up more of an index than small companies.
A fund that tracks an index. For example a fund that tracks the FTSE 100 stock index would buy all the stocks in the index with the same weights as the FTSE 100. In this way the fund will track the upward and downward price movements of the index very closely. Any deviation is known as tracking error. Passive funds try to use economies of scale to track as cheaply as possible and their fund management fees tend to be very low, although this depends on the asset class.
Investors profit from shares in two ways: capital appreciation as the share price increases and dividend income. Any profits generated by the company are either paid back to investors or re-invested in the company, and if re-invested wisely this will increase future income. The value of a company therefore depends critically on the amount of profit (earnings) it can generate. The most widely used measure for shares uses the ratio of the share price (P) to the earnings (E) generated by the company: this is the P/E ratio. A “normal” P/E is around 10 but this varies widely between industries.
For example startup companies have the potential for large earnings in future and often trade at high P/E values, sometimes in the hundreds or thousands. At the other extreme utility companies offer safety through their steady and reliable dividend payments and these companies are not expected to grow earnings like a startup and trade at much lower multiples. Another factor is risk appetite or animal spirits: when the market is in a buoyant mood investors often pay more for the same earnings across all sectors, and during a crisis investors pay a lot less for the same earnings.
One way to gauge how well the economy in a country is doing is to call the Chief Executive Officer of every large company and ask “how’s business?”. To save you time there are surveys that effectively do that. They don’t actually phone the chief exec, instead a survey is sent to the person at the company who is responsible for buying or selling goods and services. They are given a standard set of questions on the company’s output, the number of new orders, the prices of goods and services they buy and sell and their level of employment.
The questions are of the form: will this get worse, remain the same or improve. Then this is converted into a number according to the good/same/worse responses. If everyone in the survey said they expect the number of employees to increase the PMI would be 100%, if everyone expected employment to fall the PMI would be 0%. That’s why 50% is the turning point: if the PMI is above 50 it shows improvement, and below 50 is deterioration.
The number is aggregated for all companies, seasonally adjusted using some statistical voodoo called X12, and then published. The main surveys are conducted by Markit, the Ifo Institute for Economic Research in Germany which produces the German Ifo PMI, the Bank of Japan which produces the Tankan survey, and Caixin which produces a Chinese PMI in collaboration with Markit. PMI is closely watched because it is a leading indicator of economic growth which affects corporate earnings and, in turn, share and bond prices.
Robo investment is the application of machine learning and artificial intelligence to fund management and wealth management. Automation keeps costs down and is used in two ways: matching individuals to portfolios based on their responses to a risk appetite questionnaire and the selection of investments in portfolios.
To convert a daily volatility to an annualized volatility you multiply by the square root of the number of trading days in a year, which is 252. This is approximately 16, so a useful trader’s trick is to annualize daily vol to annual vol by multiplying by 16. For example, if the daily volatility is 2% the annualized volatility will be roughly 32% (very close to the annualized volatility, which is 31.7%).
Shares are issued by companies in order to get funding that never has to be repaid. In return shareholders get one vote in shareholder meetings per share that they own and a right to receive dividend payments forever at the discretion of the company board. The upside on shares is unlimited but this comes at the price of high volatility.
This is because the future cash flows of a share are highly uncertain, and in the event of bankruptcy shareholders are at the back of the queue to be repaid behind bondholders. Although share prices fluctuate wildly given their high volatility over the long term they tend to track the amount of earnings they generate, which is why a common measure of share value is the price to earnings ratio.
If you want to make a profit investing you buy low and sell high, but you don’t have to do it in that order. If you think a stock is overvalued you can borrow it from someone else, sell it at what you think is a high price then wait until the price falls and buy it back at the lower price, a process known as “short covering”.
Then you return the share to the person or company from whom you borrowed it. If you are short an asset then if its value increases by 1% you lose 1% and if its value decreases by 1% you gain 1%. If you’re short and the price increases you will lose money but still have to return the stock by buying it back at the higher price in order to return it to the stock lender. In the days following a sharp fall in a stock’s price there is sometimes a brief and partial recovery which pundits often attribute to a wave of short covering: as investors who are short lock in their profit by buying back the stock this will temporarily raise its price. This post-crash rise is also called Dead Cat Bounce.
Survey data such as Purchasing Manager Surveys which are based on aggregated opinions about the future are called soft data. The name does not mean they are not interesting, in fact hard data such as Gross Domestic Product is often backward looking whereas PMI indices give limited foresight of future GDP and corporate earnings.
The ongoing fees charged by a fund. It is a percentage of the amount being managed, so if your investment is £10,000 and the TER is 1% then you will pay £100 per year to the fund manager. The cheapest funds which are usually, passive share funds, have a Total Expense Ratio of 0.07% while the most expensive, which are usually actively managed funds, can be over 3%. This payment has to cover many things.
Primarily the fee covers the management cost, which is how the fund manager generates its revenue, but also incorporates the many costs of running a fund. These include charges for trading the assets in the fund, valuing and safekeeping of the fund’s assets, accounting for and handling distribution of dividend payments, paying for compliance expertise to ensure the fund sticks to the regulator’s guidelines, producing and maintaining regulatory information documents, customer servicing, auditor fees, IT costs…
Value at Risk (VaR, pronounced to rhyme with bar) is a measure of tail risk. For example if you invest £10,000 then if the 5% daily VaR is £200 you would expect to lose £200 or more on one day out of 20. The one in twenty comes from the level of VaR that you choose, hence 5% is 1 / 20, 1% VaR would be a one in one hundred day loss (1 / 100) and so on. This VaR is daily because it is based on daily returns. Just like volatility, VaR scales as the square root of time, so to convert daily VaR to annual you would multiply by the square root of the number of trading days in a year, which is roughly 16 (square root of 252 trading days). This is the rule of 16.
If you plot the daily returns of an asset they usually form a bell-shaped distribution but the tails of the distribution, which represent the most extreme losses and gains, tend to be very large for shares and corporate bonds. In the diagram below we can see the daily returns over a 30 year period for the FTSE 100. The FTSE 100 lost 1.62% or more with a probability of 5%, so we would say that the daily VaR of the FTSE 100 is 1.62%.
To calculate a VaR you have to choose a loss level (5%) and a time period (daily). VaR is commonly used by banks and asset managers to gauge the risk of their assets. The robo investor Scalable Capital uses a VaR-based algorithm to decide which assets to buy and sell for their clients. Alternative risk measures are volatility and drawdown. See our article on the best way to measure risk.
This is the most commonly used risk measure for investments and is the typical annual percentage price move. For stocks of large companies in developed markets volatility is usually around 20% which means that in a typical year investors should expect moves, up or down, of 20%. Bonds are usually much less volatile than stocks but this depends on the maturity of the bond: bonds that have the shortest lifetime carry least risk. Volatility is given as a percentage and is annualized. To convert daily volatility to annual volatility you multiply by sixteen (which is the square root of 252 which is the number of trading days in a year). Volatility is insensitive to the sign of price movements, so large positive returns or large negative returns increase volatility. Alternative risk measures might be Value at Risk or, see our article on the best way to measure risk.