Common Financial Terms Explained

Common Financial Terms

What are the most common financial terms used by independent Financial Advisers that you need to be aware of?

What is diversification?

This means spreading your invested funds between equities and fixed income. Diversification can also cover geography, i.e., investing both here and abroad, and market capitalisation of the equities.

What are equities?

Equities is another name for shares in a company which denotes ownership of the company. As an owner, you benefit from the income the company generates and its increase in value. The value of your shares reduces if the value of the company falls.

What is a fixed income security?

They are issued by governments, large corporations and other bodies. They are often referred to as a bond, as they are a promise to pay a fixed rate of interest, on a specific date, and to buy back the security at a fixed price in the future. Between issue and being redeemed, they are tradeable, and their value will fluctuate. However, they are generally less volatile than equities and their price is driven by different forces, making them a good diversifier to equities in a portfolio.

What is investment risk?

All investments, including cash, carry some form of risk. In general terms, it is the possibility of losing some or all the value of an investment. In brief, equity and fixed income values fluctuate, and cash suffers from inflation and institutional failure risks.

What is a risk profile?

This is an assessment of an investors attitude to the potential rises and falls in their investment portfolio. Someone with a higher risk profile will hold a greater percentage of equities in their portfolio when compared with someone with a lower risk profile. Risk profile should not be the only determinate of the makeup of a portfolio as other factors need to be considered.

What is the FTSE100 or FOOTSIE?

This is the index of the 100 largest companies by capitalisation (total value) on the London Stock Exchange. The 100 constituent companies are reviewed from time to time in case what were lower valued companies have overtaken some of the constituents.

What is the Midcap?

In the UK it is the next 250 companies by value after the FTSE100. Midcap and Small Cap companies tend to outperform larger companies over time.

What is Small Cap?

In the UK, they are remaining companies in FTSE All Share (the companies listed on the main market of the London Stock Exchange) that do not qualify as FTSE100 or the Midcap 250.

What are alternative investments?

They are anything that is outside the normal definition of equities, fixed income and cash. Examples might be Private Equity, Structured Products, etc. They are often illiquid and possibly not regulated by the FCA.

What are absolute return funds?

These funds have the objective of producing a positive return, regardless of market conditions. They often have a target of inflation plus a percentage. Whilst, the concept sounds attractive, the reality has generally been disappointing. They act as a drag on a portfolio in rising equity markets and have a mixed record in protecting the investor in falling ones.

What are property funds?

When in investing in a property fund, the investor buys shares or units in the fund. In turn, the fund owns buildings, such as offices, shops, warehouses, etc. The investor benefits from the capital growth in the value of the buildings and rental income, less the funds costs. Management costs of these funds are much higher than fixed income or equity funds. Further, liquidity can be compromised if the fund becomes “gated,” refusing requests for withdrawals for a period, usually six months plus, when demand for redemptions is high. Gating is employed to protect the fund from a “fire-sale” of properties.

What is Active management?

The term active management implies that a professional money manager or a team of professionals is tracking the performance of a client's investment portfolio and regularly making buy, hold, and sell decisions about the assets in it. The goal of the active manager is to outperform the overall market.

Active managers may rely on investment analysis, research, and forecasts as well as their own judgment and experience in making decisions on which assets to buy and sell.

What is Passive management?

The opposite of active management is passive management, also known as indexing. Those who adhere to passive management maintain that the best results are achieved by buying assets that mirror a particular market index or indices and holding them long-term, ignoring the day-to-day fluctuations of the markets.

Which is better, Active or Passive?

Actively managed funds have higher fees than passively managed funds. The investor is paying for the sustained efforts of investment advisers who specialise in active investment, and for the potential for higher returns than the markets as a whole.

A fund manager’s expertise, experience, and judgment are employed by investors in an actively managed fund. Active fund managers have more flexibility. There is more freedom in the selection process than in an index fund, which must match as closely as possible the selection and weighting of the investments in the index.

Actively managed funds allow for benefits in tax management. The flexibility in buying and selling allows managers to offset losers with winners.

Passive funds are cheaper as there is no intellectual process involved.

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