11 investment terms broken down and explained

Jargon Buster: We run through 11 key investment terms that you need to know.

As part of “Talk Money Week”, an initiative that aims to get more people talking about their finances as a way of improving money management skills in the UK, we run through 11 key investment terms that investors need to get to grips with.

Active management

The managers of actively managed funds attempt to outperform a market (such as the FTSE 100 index) by researching, analysing and actively selecting investments to buy. Active funds are structured as either a unit trust or an Oeic: an open-ended investment company.

The other type is an investment trust, but they differ in that they are structured as companies listed on the London Stock Exchange and investors hold shares (rather than units).

Passive funds

In contrast to active funds, passive funds – also called tracker or index funds – aim to mirror the performance of a market. This is achieved by simply holding the same investments and weightings as the index.

Smart beta funds

Investors are no longer faced with the binary choice of picking an active fund manager or passively tracking a stock market index. There’s a third option that is growing in popularity, particularly in the US, which is a hybrid of the two. Known as ‘smart beta’ in industry jargon, these index funds or ETFs do not pick shares by market capitalisation, as a fund tracking, say, the FTSE 100 index would.

Instead, they actively decide which shares to track by targeting shares that possess certain characteristics. For example, some smart beta funds follow a basket of companies that are reliable dividend payers, while others target the highest-yielding shares on a particular index.

Ongoing charges figure

The ongoing charges figure (OCF) is the annual cost of investing in a fund, expressed as a percentage of the value of your investment. Confusingly, trading costs (incurred when the fund manager buys and sells investments) are not included in the OCF, so the true annual cost will be higher than the stated OCF. Research by Fitz Partners estimates that on average trading costs add 0.25% to the OCF. Given that active equity funds typically have a clean share class costing around 0.85%, this would push costs above 1%.

Share classes

Here’s what you need to know: an investor buying a fund today is likely to see the following share classes: retail or 'R', institutional or 'I', clean or super-clean (which can be prefixed by any random letter). Income units are normally designated 'inc' and accumulation abbreviated to ‘acc’. There are other share class options, for example 'hedged', which strips out currency movements. The best course of action is simply to buy the cheapest share class on offer and then choose between taking any income produced by the fund or opting for income to be reinvested.

Mifid II 

It sounds like the title of a movie sequel, but Mifid II won’t be shown at your local picture house anytime soon. It is instead a huge piece of EU legislation that aims to make financial markets more efficient and transparent. More than one million paragraphs of rules have been written, but as far as investors are concerned the main thing to know is that there’s a good chance fund charges will fall.

Fund managers have in the past billed investors for research costs as part of a portfolio’s total transaction costs. But under Mifid II these two charges have to be separated. In response most fund managers have decided to dip into their own pockets for research fees, meaning fund charges will reduce, albeit only by around 0.1 to 0.2 per cent typically.

Platform or online broker

A middleman that allows investors to set up accounts (including Isas), buy or sell funds and other investments online, and view the value of the investments they hold there.

- Here is how to find the best value broker for your Isa portfolio 

Stock market correction

When volatility strikes and shares fall, the question on financial commentators’ lips is whether the falls are a ‘market correction’, ‘stock market crash’ or the first sign of a ‘bear market’. This is how to tell. First, don’t confuse a couple of bad days for markets as a market correction; the falls have to be 10 per cent or more from the index’s 52-week high to count as a correction. A stock market crash, as the name implies is more severe, involving a 10% drop over one or two days. A bear market, in contrast, is when an index falls 20% or more from a recent peak.

But at times of stock market turbulence, it is worth remembering that volatility is part of the deal in investing in equities. It’s the price investors pay for the fact that over the long run, putting money into shares rather than leaving it in cash will yield greater rewards.

The Sharpe Ratio

Aa useful aid for investors hunting for active funds that stand out from the crowd is the Sharpe ratio This is a way of measuring the historical risk-adjusted return on an investment. In other words, how much excess return you have received from an investment such as a unit or investment trust to compensate for the risks attached. The higher a fund's Sharpe ratio, the better its returns have been relative to the risk it has taken on.

It is calculated as the average previous return from the investment (for example over the past three years) minus the risk-free return over that period (for example that from Libor), divided by the standard deviation of the investment (a measure of risk that looks at the diversion of actual returns from expected returns).

Yield

A percentage figure showing how much a company pays out in dividends relative to its share price. 

Dividend payout ratios

A company has several options to make use of its earnings. It may opt for capital expenditure to secure future growth. Alternatively, it may opt to save, or pay down debts. Or it can reward shareholders by paying out dividends. The dividend payout ratio is the percentage of a company’s earnings that it pays out in dividends to shareholders.

British American Tobacco, for instance, had a payout ratio of 69 per cent in 2016. That means 69 per of its net income in that year went to shareholders in the form of dividend payments. Amazon, meanwhile, is a company which never pays dividends and therefore has a dividend ratio payout of zero. Companies can also have dividend payout ratios above 100 per cent, meaning that they are paying out more in dividends than they earn in net income. This is often the case for firms with very cyclical earnings. Generally, the higher the dividend payout ratio, the more risk there is of the company cutting its dividend.

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