Investment terms you need to know
The investment world sometimes seems like another planet. You’d like to visit but you have no idea where to go or what to do. It doesn’t help that when you finally venture into it, everyone seems to be speaking a strange language.
You need to be armed with the right vocabulary to master this strange new world. In the third lesson of Moneywise's Investment School, we offer a translation service - laying bare the language of investment.
The first thing to understand is what an investment vehicle is. Put simply, it's what you put your money in and there are two main types - unit trusts and investment trusts.
A unit trust, or open-ended investment company (OEIC), is 'open-ended', which means it can continue to take cash from everyone who wants to invest for as long as there are willing investors. The value of the fund will rise and fall with the value of the assets it holds.
An investment trust is similar in many ways but is 'closed', which means instead of an infinite number of people being able to invest, the fund is split into shares of which there are a fixed number. You buy into the fund by buying these shares, and sell up by selling the shares on to another investor.
Because investment trust companies are quoted on the stock exchange, the price of shares is determined by the stockmarket according to supply and demand, and may not equal the underlying value of the trust's own investments, known as its net asset value or NAV. This means they can be sold at a discount or a premium from that value.
Another big difference is that investment trusts can borrow money in order to invest, a process known as gearing. This magnifies its exposure to market movements, boosting returns in the good times but increasing losses when markets fall.
Once you’ve picked the unit or investment trust you want to invest in, the next thing you need to decipher is the key features document from the fund management company. This is your roadmap to the fund.
You'll come across the investment objectives in it first, which explain the kind of things it invests in, the limitations and the strategy of the fund.
Within the investment performance section you'll find a host of information, including a chart showing past performance for a number of years (cumulative performance) and a table of growth each year for the past five years (discreet performance). The authorities have drummed it into us that past performance is no guide to the future but it does hold clues.
Take the Fidelity Special Situations fund, for example. A glance at performance tables shows that if you invested £1,000 a year ago it would be worth less than £950 today. If you invested the same amount three years ago it would be worth just under £1,400, and if you invested it 10 years ago it would be worth just under £2,500.
From this we can see it's a volatile fund that invests in companies with the potential to do better than their rivals, or much worse. It tells you about the risks you are taking.
There are a few other things to look at. One is the quartile a fund has been in. This tells you how it does in comparison with funds that are fairly similar. If it is first-quartile consistently then it generally outperforms, and if it is fourth, then it underperforms.
Take the well-liked Artemis Income fund. Over the past year it has been first-quartile, over three and five years it was second, and since launch it has been first-quartile. This isn’t a guarantee that this performance will continue but shows robustness in the past. Of course, the quartile positioning needs to be taken with a pinch of salt.
Not every fund in the sector is aiming to do exactly the same thing so we wouldn’t expect the performance to be the same.
Another thing to familiarise yourself with is the star rating. A number of companies offer these, including Morningstar, FE Crown Ratings and Lipper.
These do in-depth investigations into the funds, their strategy, management, past performance, volatility and everything else. Then they give them an overall star rating.
Morningstar gives between three and five stars depending on how well they’ve performed compared with similar funds (adjusted for things such as risk and charges).
Likewise there are FE Crown Ratings, which award up to five crowns on a similar basis. Lipper is more complex because ratings are given in categories including: total return, consistent return, preservation, tax efficiency and expense.
The top funds are called Lipper Leaders, the rest are ranked 1 to 4, where 4 is best. Of course, it doesn’t help that the ratings agencies don’t always agree on what makes a good fund but a generally strong showing across them is a good sign. Artemis Income, for example, has five stars from Morningstar and three crowns from FE.
The key features document also contains information about charges - starting with the initial charge, or entry charge . If you invest through a fund supermarket you'll get a good discount on this and bring charges that can be up to 5% down closer to 1.25%.
It will also list the ongoing charges or annual charges, including the annual management charge, or AMC, which covers the cost of the research and expertise of the fund managers, the administration charge, the registrar charges and the fund expenses, which cover things such as the fees it needs to pay.
These are often added together to show you a total expense ratio, or TER, which covers most of the charges your fund faces in a year.
Also look out for performance fees. These are more common in some sectors than others so, for example, absolute return funds are more likely to have them. Take the Cazenove Absolute Target fund. It will charge 20% a year of the increase in the NAV of the fund in every year it makes a profit.
Once you have mastered the basics, there are specialist investment sites with their own measures, from the sharpe ratio to the alpha and beta returns.
Usually charged as a percentage of returns for performance above a specified benchmark, such as an index. The fee can range from 10% to 20% of total investment returns on a low starting benchmark such as Libor and investors could find themselves paying extra fees for merely average performance. Note that these funds do not compensate investors when the manager underperforms the benchmark.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
Net asset value
A company’s net asset value (NAV) is the total value of its assets minus the total value of its liabilities. NAV is most closely associated with investment trusts and is useful for valuing shares in investment trust companies where the value of the company comes from the assets it holds rather than the profit stream generated by the business. Frequently, the NAV is divided by the number of shares in issue to give the net asset value per share.
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
Annual management charge
If you put money in an investment or pension fund, you’ll not only pay a fee when you initially invest (see Allocation Rate) but also a fee every year based on a percentage of the money the fund manages on your behalf. Known as the AMC, the actual percentage varies according to the particular fund, but the industry average for active managed funds is 1.5%.
Investors who borrow money they use for investment and use the securities they buy as collateral for the loan are said to be “gearing up” the portfolio (in the US, gearing is referred to as “leveraging”) and widely used by investment trusts. The greater the gearing as a proportion of the overall portfolio, the greater the potential for profit or loss. If markets rise in value, the investor can pay back the loan and retain the profit but if markets fall, the investor may not be able to cover the borrowing and interest costs, and will make a loss. Also used to describe the ratio of a company’s borrowing in relation to its market capitalisation and the gearing ratio measures the extent to which a company is funded by debt. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.
Absolute return funds
Absolute return funds aim to deliver a positive (or ‘absolute’) return every year regardless of what happens in the stockmarket. Unlike traditional funds, they can take bets on shares falling, as well as rising. This is not to say they can’t fall in value; they do. However, over the years, they should have less volatile performance than traditional funds.
Key features document
The key features document (KFD) gives consumers the main points about any financial product or service they are considering purchasing without having to resort to the fine print. The KFD must include key headings outlining the product, its features, benefits, aims, risks and the requirements the consumer has to meet as well as a Q&A section. Although no two KFDs are exactly alike (each product requires a bespoke KFD), the FSA issues guidelines for how financial services companies should present the KFD to prospective customers.