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Glossary

Glossary

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E

EARNINGS PER SHARE

This key number expresses the earnings available to shareholders in per share terms – hence the term earning per share.

So if a firm makes profits after tax of say £100m and has 50m shares in issue, EPS is £100m/50m or £2. The higher this number the better from a shareholder’s perspective although the overall trend is also important over say a five year period. EPS forms a key part of a standard price to earnings (P/E) ratio.

EBITDA

Earnings before interest, tax, depreciation and amortisation (EBITDA) is a number that some analysts prefer to use as a profits measure when analysing companies.

It tries to solve some of the weaknesses inherent in the profits after tax figure. In particular it takes out two of the more subjective costs – depreciation and amortisation of fixed assets – in an attempt to get closer to a cash based profits figure. It also removes interest, a financing cost, and tax. As a result EBITDA will usually be a higher number than profit after tax.

ENDURING POWER OF ATTORNEY (EPA)

These were documents that gave someone else the power to make decisions concerning your welfare and finances.

They have now been superseded by the Lasting Power of Attorney. If you have an existing EPA you may wish to discuss updating it with an advisor.

ENTERPRISE INVESTMENT SCHEME

An enterprise investment scheme (or EIS) is a way for those people who want to invest in the shares of risky, young companies tax-efficiently to do so.

There are generous income tax, capital gains tax and inheritance tax reliefs available. These are subject to certain criteria which include that the original investment must be held for at least three years. It should also be noted that tax relief alone is not a strong enough reason to make an EIS investment and you should fully understand the risks before committing.

ENTERPRISE VALUE

When valuing a company there are several choices. Stock exchanges tend to quote firms on the basis of their market capitalisation – the number of shares in issue multiplied by the current share price.

However this measure doesn’t explicitly consider the impact of a firm’s decision to take on debt finance nor does it consider the value of any cash held by the firm. Enterprise value tries to solve this by valuing a firm using the market value of its debt, net of any cash on its balance sheet, plus its equity. So if a firm has £50m of debt in issue and £50m of equity, its enterprise value (EV) is £100m. This can be used in a valuation measure preferred by some analysts – EV/EBITDA.

EQUITY RISK PREMIUM

Shares are riskier than say cash balances or government gilts because they are more price volatile and carry a higher overall risk.

That means investors should expect to earn a higher return for investing in equities as opposed to something safer. The difference between the return you expect to earn from a relatively low risk asset and the return you expect from equities is known as the equity risk premium. So for example if low risk government bonds offer a yield of 3% and you expect to get a return from equities of 8%, the equity risk premium, or ERP, is 5% (8%-3%).

EUROBOND

When a UK firm borrows sterling from UK investors, it is known as a domestic bond issue.

However it is also possible for overseas firms to target Eurocurrencies when borrowing – that is money on deposit outside of its country of origin. For example if a US company wants to raise a euro-denominated loan here, the resulting bond is known as a Eurobond. Note that the issuer need not be European, the currency can be any currency held outside its country of origin and the investors being targeted to buy the security may be based in any country.

EXCHANGE TRADED FUND

Also known as an ETF, this is a fund that gives investors exposure to the movement in an underlying index or sector or commodity without them having to own that underlying asset.

Instead the investor owns an exchange traded share that tracks it – one of the earliest ETFs tracked the S&P 500 for example. Most ETFs are passive in that all they do is try to replicate the moment in the chosen underlying asset. For this reason they tend to be cheaper than other funds. The downside however is an ETF will at best only ever match the performance of a particular asset rather than beat it.

EXECUTION ONLY

Brokers who simply execute trades on behalf of clients and offer no advice are called execution only brokers.

This service is generally cheaper than an advisory service but only suited to clients who know exactly what they want to buy and/or are comfortable running a diversified portfolio without support.

EXECUTOR

When a person dies someone has to take responsibility for valuing their death estate, paying the relevant inheritance tax and distributing the remaining assets according to the terms of the deceased person’s will.

This job – known as probate – is done by an executor, who may typically be a family member or a paid professional.

W

WILL

Wills are legal documents that deal with some crucial issues that only arise when you die.

F

FINAL SALARY SCHEME

These are increasingly rare pension schemes (unless you are a government employee) where an employer guarantees to link your pension to your final salary whilst you were in employment.

The reason they are rare is that this puts all the risk onto an employer in terms of whether they will have the funds available to meet this commitment. A more common form of pension these days is defined contribution, or money purchase. Here an employer and an employee each may contribute to a pension fund the value of which is not fully known until the employee retires. As such the risk is borne by the employee in terms of what this fund will pay for on retirement.

FISCAL POLICY

This is the mechanism by which governments adjust their tax policies and spending levels.

For example, in order to stimulate growth they may try cutting tax (to encourage entrepreneurship) and/or boost spending in order to directly influence the jobs market and generate confidence. Opinion divides as to which measures are the most effective.

FIXED ASSETS

These are the long-term assets of a business intended for revenue generation and not onward sale.

Examples include land and buildings, motor vehicles and computer equipment. Usually they are recorded in a firm’s balance sheet at their acquisition or purchase price and then gradually written off via a depreciation charge against profits at a rate that reflects their estimated useful life to the business.

FIXED INCOME SECURITY

Also known as “bonds” these are IOUs issued by companies and governments.

They carry a fixed coupon so the income return to an investor is known in advance as is the final redemption date and the value of the bond at that redemption date (its “face”, “par” or “nominal” value). From an issuer’s point of view they can offer access to a relatively cheap source of finance. For an investor fixed income securities can be a way to secure a relatively predictable income stream and diversify a portfolio.

FIXED PROTECTION

This describes a way for a pension saver, who is in danger of breaching the Lifetime Allowance (LTA), to exclude additional assets from the scope of the LTA penalty charge.

It does this by fixing the LTA at a higher amount based on previous years’ allowances.

FLOATING RATE NOTE

This is a debt security where the interest paid to the holder floats up or down in accordance with a benchmark rate of interest (such as LIBOR) rather than being fixed.

Since the coupon payments are less predictable for the issuer with this type of security they are less common than simple fixed income securities. In theory the interest payments on these securities can be linked to any interest rate but typically one of the interbank rates is chosen. They should not be confused with index-linked securities where the benchmark is usually a rate of inflation.

FREE CASH FLOW

This is the cash flow that is left once a firm’s operating cash flow (the cash it generates from the heart of its trading operations as shown towards the top of a cash flow statement) has been adjusted for non-discretionary payments such as the interest on debt and the tax bill.

It is also common to adjust the number for the capital expenditure required annually to maintain a firm’s business operations. Free cash may be used by the directors to pay a large dividend, invest in new operations or even pay for a share buyback. As such it is a key number for investors.

FREE CASH FLOW YIELD

This is a metric used to get a view on whether a firm is over, or under, valued in cash flow terms.

It compares the annual free cash flow per share to the price per share as a percentage. So if FCPS is 10p and the share price is 100p, then the FCF yield is around 10%. The higher this is, the better value the share. Cash flow is thought by many analysts to be more reliable than earnings or even dividends, which is why this number is commonly quoted by analysts alongside the better-known P/E ratio and dividend yield.

FREE FLOAT

This is the proportion of a firm’s total shares that can be freely bought and sold and are therefore not held solely for directors, other firms within a group, or even the government.

This is an important number because if a firm has a low free float the shares may be very volatile if there is strong investor interest in them. Stock exchanges usually require a firm to have a minimum free float before they can apply for a listing.

FUND MANAGER

Someone paid to run an active or passive fund.

Active funds are those where a fund manager makes decisions about what should be held within the fund according to an investment mandate. They are free to buy and sell securities on behalf of investors in order to meet the objectives of the fund (for example to achieve a certain level of income or capital growth, or both). There are two basic types of UK fund – open ended (this includes unit trusts), and closed ended (which includes investment trusts).

FUND OF FUNDS

Most funds invest directly in a particular asset class whether that is shares, bonds, property, currencies or commodities.

However fund of funds specialise in investing in the best funds instead. They focus on selecting the best managers and allocate their capital to those funds. As a result of this two-tier approach, which means an investor is paying for the expertise of both the underlying fund manager and the fund of funds manager, charges tend to be slightly higher than for standard funds.

FUNDAMENTAL ANALYSIS

The analysis of a company, sector or even economy from the bottom up, often using ratios.

This approach is common amongst “value investors” who believe that inefficient markets present opportunities to buy stocks for less than they are really worth.

FUTURES

These are derivatives that try to mirror the movement in an underlying asset without requiring a buyer or seller to actually take or make delivery.

This can be useful for hedging purposes. For example you might hold a large portfolio of FTSE 100 shares and be worried about a short term price dip. Rather than selling the portfolio and triggering a tax bill plus all the hassle and expense of recreating it when conditions improve, you could sell a FTSE 100 future. Set up correctly this will compensate you for any dip in the FTSE 100 short-term whilst allowing you to retain your portfolio. Futures are typically exchange traded and as such tend to be easy and relatively cheap to use. However they are only suitable for experienced investors.

Y

YIELD CURVE

A yield curve is a graph that shows how yields on similar fixed income securities change..

YIELD CURVE SHAPE

This is watched closely by investors because a change can be early warning of broader changes in the economy.

G

GDP GROWTH

Gross domestic product (GDP) is a broad measure of the wealth being generated by an economy.

It is the total value of goods and services produced by an economy as measured by the Office for National Statistics (ONS). When things are going well, GDP will tend to rise and the reverse is true. One problem is in capturing reliable, up-to-date data, which is why the published number can sometimes be revised once more accurate figures are available. There are several ways to express this figure, whether as a total, on a per capita basis or in terms of its overall change. Economists try to predict GDP growth, since it is such a key number. That is where organisations such as the Institute for Supply Management (ISM) and the Institute for Economic Research (IFO) data often come into play.

GEARING

This is the extent to which a firm is debt, rather than equity, financed expressed as a percentage of its total funding.

So for example if a firm has £100m of debt and £200m of equity, gearing is 33% (£100/£300m). Low gearing makes a firm relatively safe and low risk but also unlikely to sparkle in net earnings terms. Highly geared firms with poor cashflow on the other hand can be more volatile in share price terms as debt, which usually carries a fixed interest cost, boosts the return to shareholders when times are good but acts as a drag in a downturn.

GIFTS INTER VIVOS

These are gifts made during a person’s lifetime that are free of any obligation on the recipient.

The motive for making such a gift may be to avoid, or reduce, an inheritance tax liability (see potentially exempt transfer).

GILT

These are IOUs issued by the British government in order to meet the shortfall between its revenue (mainly tax) and its expenditure on public services and defence.

They are generally sold at competitive auctions to institutional investors looking for a relatively safe home for funds however they can subsequently be bought by anyone including retail investors. Gilts mostly carry a fixed income return in the form of a coupon and can be freely traded between issue and final redemption by the government. The nearest US equivalent is the Treasury.

GOODWILL

When one business buys another it may pay more for it than the value of its tangible net assets.

That’s because buyers are often prepared to pay a premium for intangible assets such as reputation, brand name and market share, none of which will be recorded in the books of the target firm because accounting rules don’t allow it. So let’s say that a target has assets of £300m in its books and a buyer is willing to pay £500m for the firm – goodwill is the difference of £200m. This is recorded as an asset in the books of the predator.

GROSS MARGIN

This is the difference between a firm’s sales and cost of sales expressed as a percentage.

So for example if a firm makes annual sales of £500m and incurs cost of sales (direct costs of making sales) of £400m, gross profit is £100m (£500m-£400m) and the gross margin is 20% ((£100m/500m) x 100%). The higher this number the better, as it indicates the extent to which the core activities of a business are profitable. A firm with a low gross margin has little financial wiggle room should trading take a downturn.

Z

ZERO

Many securities carry some sort of income return, whether a coupon on a fixed income security or a dividend on a share.

I

INCOME DRAWDOWN

This is a facility that preserves your pension lump sum into retirement and allows you to draw off income rather than say converting it into an annuity.

The amount of income that can be drawn in this way used to be capped at a percentage of what is known as the GAD (Government Actuary’s Department) rate. However, under the pensions freedom rules this is no longer the case and you can withdraw as much as you like, subject to the fact that it may be liable for income tax.

INCOME TAX

This is the tax that individuals suffer on income whether earnings or investment related (so it applies to interest on cash and dividends received from companies).

The rate varies depending on the level of income earned. There are various ways to reduce the bill including annual allowances and the use of individual savings accounts.

INDEX LINKED GILT

This is a government IOU that also pays a variable rate of interest but this time linked to a rate of inflation – typically this has been the retail prices index.

The British government issues fewer of this type of gilt because coupons can be hard to predict compared to a standard fixed income security. Usually the final redemption payment is also linked to an inflation rate which also makes these IOUs harder to forecast in cash flow terms.

INDICES

Indices started off as baskets of stocks, carrying a single price, designed to make life easier for investors.

So for example the FTSE 100 index represents the market capitalisations of leading UK shares in one number. As such it is a useful way to get a snapshot of what is happening in the stock market and provides a useful performance benchmark for investors who hold portfolios of blue chip UK shares. It can also form the basis of derivatives contracts such as futures and options. With stock indices the name usually tells you who puts the index together (FTSE is short for Financial Times and London Stock Exchange) and the number of firms represented (about, although not always exactly, 100 in the case of the FTSE 100).

INHERITANCE TAX

The tax paid on a UK domiciled (the UK is their legal home) person’s death estate.

On death an executor takes responsibility for valuing a deceased person’s assets for inheritance tax purposes. Tax is then levied at a flat rate of 40% on any amount above the exemption limit. There are various ways this tax can be mitigated including gifting assets while the donor is still alive.

INTERDEALER BROKER (IDB)

These are specialists who act on behalf of market participants seeking anonymity for certain trades.

They will often act for example for market makers who want to buy or sell a large quantity of a security without giving away their identity to other counterparties. An IDB will contact other willing counterparties on their behalf and set up the deal in return for a commission. That’s why they are sometimes known as “the market maker’s market maker”.

INTEREST COVER

If you have a large mortgage you may have done a comparison between your salary and the interest you pay each month as an affordability check.

The same principle applies to firms that borrow money. Interest cover is the number of times profit before interest covers the annual interest expense. The higher the result, the better, with anything above 4x considered to be reasonably good. The calculation can also be done from a cash flow perspective by comparing cash flow from operating activities to the amount spent on interest.

INTEREST IN POSSESSION TRUST (IIP)

These are used where a settlor wants to create a lifetime interest in say the income from a property, perhaps to benefit a spouse, but with the ultimate intention of leaving an asset to someone else, say children.

An IIP is a trust structure that can achieve this, subject to certain conditions.

INTESTATE

If someone dies intestate, they die without a will.

That means the distribution of any assets they hold on death is carried out according to rules devised by the state (Intestacy Laws) rather than according to the instructions of the deceased that would normally be contained in a will. For this reason, it is better for most people to make a will so that they can be sure about how their assets will be distributed on death.

INVESTMENT GRADE

If a bond is rated investment grade it means that the ratings agencies such as Moody’s, Standard and Poor’s and Fitch do not believe that the risk of default is high.

INVESTMENT TRUST

This is essentially a listed firm that buys shares in other companies.

INVESTOR VISA

An investor visa is a special visa available to overseas persons with more than £1m to invest in the UK.

IPO

An initial public offering (IPO) is the mechanism by which a company offers its shares for public sale for the first time.

Typically this is done either because the existing directors want to cash in and/or the firm in question wants to raise new finance for expansion. IPO shares are often sold directly to institutions but may be offered to the public too. Demand for these new shares can be hard to predict so the selling firm will usually call on the services of an investment bank. These banks advise on the timing of any sale, the price of the shares being sold and help with regulatory issues. They may also act as underwriters, buying up any shares that are not wanted on the IPO date.

ISA

An individual savings account, or ISA, is a way to protect cash and investments from income tax and capital gains tax.

It works as a tax shelter – you choose the underlying asset and it provides the tax protection. You can protect a bank or building society account and/or stocks and shares. The amount you can invest each tax year is capped by the government and works on a use it or lose it basis – fail to invest the limit by the end of the tax year, either as a lump sum or a regular monthly investment, and you lose the allowance for that year.

J

JISA

This is short for “junior ISA”.

JUNK BOND

This is a catch-all phrase for bonds that are of sub investment grade quality and are therefore higher risk than safer equivalents.

L

LARGE CAP STOCKS

These are shares in big firms that are typically available on the top lists of public exchanges such as the London Stock Exchange.

LASTING POWER OF ATTORNEY (LPA)

This is used so that someone can give key decision-making powers to someone else to enable them to act on their behalf.

LEGAL SHAREHOLDER

If your name appears on a share register then you are the legal owner of the underlying shares.

LEVERAGE

This is a US term which is broadly equivalent to the UK term gearing.

LIBOR

The London Inter-Bank Offered Rate is a key benchmark rate for financial markets that influences the price of many products including mortgages.

LIFETIME ALLOWANCE

This sum, which is set by the government, represents the maximum amount you can withdraw from a pension fund without being hit for additional penalty tax charges.

LIMIT ORDER

An order to trade at no worse than the price stated.

LLOYD’S MEMBER

The insurance market known as Lloyd’s of London is funded by its members.

LOAN TO VALUE

This term describes the relationship between a loan secured on an asset and the value of that asset.

LONDON STOCK EXCHANGE (LSE)

This is the main market in London for publicly traded shares.

MARGINING

This is the method used by derivative counterparties to protect each other from default.

M

M&A

An abbreviation for mergers and acquisitions, this phrase describes the two main ways for firms to grow by combining forces.

MARK TO MARKET

This is the process of reflecting the latest prices at the end of a trading session in a portfolio of securities.

MARKET CAPITALISATION

The value of a firm’s equity computed by multiplying the number of shares it has in issue by the current share price.

MARKET MAKERS

These are professional traders, often working for banks, who commit to provide liquidity in securities so that other market participants can buy or sell them.

MARKET ORDER

This is an instruction to buy or sell shares at the best available market price.

MEAN

This is also called a simple average and an arithmetic average.

MEAN REVERSION

Most things in nature, as well as financial markets, tend towards their long-term mean.

MEDIAN

A way to calculate an average value, the median looks for the item in the middle of a sample.

MID CAP

These are stocks that are not large enough to be large cap but are nonetheless relatively big and widely held and traded.

MINORITY INTEREST

These arise where a firm is not owned outright by another firm – its “parent” company.

MODE

This is an average value that is calculated simply by looking for the most common item in a sample.

MONEY LAUNDERING

This is the process by which a criminal tries to convert money and other assets that are acquired from crimes (these include drug trafficking and terrorism) into legitimate funds that will not attract any attention from regulators or other authorities.

MONEY PURCHASE SCHEME

Also known as defined contribution schemes, money purchase schemes are a way of building up a pension fund.

MONEY SUPPLY

Many people cannot afford to buy their home outright. A mortgage is a loan secured against a property that funds the part of it a borrower cannot afford themselves.

MOVING AVERAGE

A moving average is a way of assessing price trends. The problem with looking at say single daily prices for stocks is the underlying trend, up or down, can be masked by short term volatility.

MULTIPLE EXPANSION AND CONTRACTION

Share price rises can be driven by two factors – one is an increase in earnings and the other is multiple expansion.

MUTUAL FUND

This is the umbrella US term that refers to their equivalent of unit trusts and open ended investment companies.

N

NET REDEMPTION YIELD

This is the yield to maturity on a fixed income security, also known as the gross redemption yield, adjusted for income tax.

NEW ISSUE

This term describes the situation when a security is first released to the market and made available for trading.

NIL PAID RIGHTS

When a rights issue takes place an investor is usually offered the chance to buy new shares in a firm at a discount to the current price.

NIL RATE BAND

This is the total amount of a Death Estate (the assets you leave behind on death) that automatically escapes inheritance tax (IHT).

NOMINAL VALUE

This is a fixed amount of a fixed income security – usually £100 – and determines both the amount of the coupon, based on the fixed coupon rate, and the final redemption value when the security is redeemed by the issuer.

NOMINEE

Rather than record every share purchase on behalf of a client in separate designated accounts with a settlement system, a broker may operate a nominee instead.

NORMAL MARKET SIZE

This is the minimum number of securities for which a market maker is obliged to quote a price at which they are willing to trade according to London Stock Exchange rules.

O

OFFER PRICE

There are two prices at which most securities can be traded – a bid and an offer.

OPEN ENDED FUND

Examples of this type of fund include unit trusts and open ended investment companies.

OPERATIONAL GEARING

This is the relationship between a firm’s fixed and variable costs.

OPPORTUNITY COST

Most financial decisions carry an opportunity cost – the value of the alternative course, or courses, of action available to you at the time.

OPTION

This is a derivative that gives the buyer a degree of protection against falling prices.

ORDER BOOK

Deal instructions to buy and sell shares, or other securities, that have not yet been executed are often held in an order book..

OVER THE COUNTER (OTC)

There are basically two ways to do a deal to buy or sell a security – on exchange or over the counter.

P

P/E RATIO

Price to earnings ratios are a common way to assess whether a share is cheap or expensive.

PEG RATIO

Price to earnings ratios are a common way to assess whether a share is cheap or expensive.

PENNY STOCK

This is the name typically given to the shares of small high risk firms.

PENSION

When you stop working you need an income to pay for your retirement – enter the pension.

PERKS

Investors usually buy shares hoping for capital appreciation and/or income.

PLACING

This is a way for an investment bank to sell shares on behalf of a client, perhaps when they first come to market by way of an IPO.

PONZI SCHEME

Also known as “robbing Peter to pay Paul” this is an illegal scheme whereby a fraudster comes up with a plausible sounding investment opportunity with a near-guaranteed return and persuades an initial batch of investors to commit money.

POTENTIALLY EXEMPT TRANSFER

Assets that are given away by their owner before death may not form part of that person’s death estate on death and may therefore not attract inheritance tax.

POUND COST AVERAGING

This is a feature of regular, as opposed to lump sum, investing that can smooth out volatility and boost returns depending on what the underlying market does over the investment term.

POWER OF ATTORNEY

A lasting power of attorney (LPA) allows you to appoint someone (your attorney) to make decisions for you.

PREFERENCE SHARE

Firms issue two types of share – preference and ordinary, with the latter being more common.

PRICE TO BOOK RATIO

This ratio compares the current share price of a firm to the book value per share to give an indication about whether it is cheap or expensive.

PRICE TO BOOK VALUE

This is the relationship between the market capitalisation of a firm and the value of its assets as viewed by an accountant (“the book”).

PRICE TO SALES RATIO

Used in sectors where firms struggle to make profits, this ratio compares a firm’s share price to revenue (or, sales) per share.

PRIVATE EQUITY

This umbrella term for essentially private investment covers two main activities..

PROFIT AND LOSS ACCOUNT

A financial statement that summarises the revenue (or “sales”) that a firm has generated over a year less the costs incurred.

PTM LEVY

This is a £1 charge levied on share transactions valued at £10,000 or more which helps to pay for the Panel on Takeovers and Mergers.

PUT OPTION

A contract that gives the person who buys it (the “holder”) the right, but not the obligation, to sell an asset (perhaps 1,000 shares) at a fixed price (“the strike”) on or before a specified date.

Q

QUANTITATIVE EASING

This is the process whereby central banks create money electronically which enables them to buy government securities.

QUANTITATIVE TIGHTENING

The reverse of QE (above), this is the process whereby a central bank will try to reverse monetary stimulus and reduce the size of its balance sheet in the process.

R

RAINY DAY FUNDS

This is money that all of us should set to one side in a liquid home, such as a bank account.

RDR

This is short for Retail Distribution Review. An initiative from the regulator, at the time the FSA, this is aimed at making the retail financial services market more professional, transparent and fairer..

REAL YIELD

This is the gross, or “headline” yield on an investment, adjusted for inflation..

REDEMPTION YIELD

This is the total annual rate of return on a fixed income security that takes into account income and any capital gain or loss arising before it matures.

RESEARCH ANALYST

These are professionals paid to give their opinions on securities.

RETAIL SERVICE PROVIDER

This is a firm that acts as a link between a retail broker and the London Stock Exchange where a broker does not use the exchange’s direct market access option to place and execute trades directly via the LSE order book.

RETURN ON CAPITAL EMPLOYED

Also known as ROCE this is the total return available from a firm.

RIGHTS ISSUE

This is where a company that is already listed on a public market makes a fresh issue of shares in a bid to raise more finance from its shareholders.

RISK PREMIUM

As a rule of thumb in investing, the more risk you take the higher the return you should expect.

A

ABSOLUTE RETURN FUND

Most traditional funds make money when markets are rising and lose it when they are falling.

As such they are judged by the returns that they achieve relative to their peer group. However absolute return funds are judged on their ability to generate positive returns regardless of market conditions and the performance of other funds. They may, for example, set a target of achieving returns above a benchmark such as LIBOR. In order to thrive when markets are trading sideways or down they often employ derivatives and may allocate a significant proportion of the fund’s assets to cash to preserve capital.

ACTUARY

An important part of managing a pension fund is being able to forecast key variables such as how long people will live in retirement, what their pension will cost the fund and what sort of investment returns the pension fund can earn on its assets.

Actuaries are employed to make this type of estimate. Typically they work for the government, for life assurance firms who provide pensions and sometimes for companies who run final salary pension schemes for their employees and therefore need advice on how much money to pay into the fund.

ADVISED DEALING

An entry level stockbroking service where a client manages their own portfolio. A broker typically offers advice on single securities and funds rather than the composition or suitability of an entire portfolio.

This service level suits investors who take an active interest in the market and are happy to be directly involved in making their investment decisions.

ADVISED PORTFOLIO

This phrase describes a comprehensive stockbroking service where you are the manager of your investment portfolio.

A broker will provide advice on the design and construction of a portfolio and its on-going management plus provide individual stock recommendations.

AIM

The London Stock Exchange alternative investment market (AIM) is a market place for small, fast-growing firms that don’t qualify for a full listing but that want to raise capital from the public.

It helps these younger firms to gain recognition and also raise capital. Aim shares tend to be more volatile than their main market counterparts but can nonetheless be held within an Individual Savings Account (ISA).

ALPHA

This is the amount of added value that a fund manager brings to a portfolio that can be ascribed to their stock picking skills.

It is the gain above and beyond the one that an investor could expect from a portfolio based simply on the overall direction of the market and the extent to which the portfolio usually mirrors that movement (known as its “beta”).

AMORTISATION

This describes the way a firm writes off the value of an intangible fixed (long-term) asset over its remaining useful life.

For example if a firm has a software license worth £100m and the directors decide it has a useful life of ten years, then each subsequent profit and loss account will bear an amortisation cost of £10m (£100m/10).

ANNUAL ALLOWANCE

You can save as much as you like towards a pension each year, however there is a limit on the total amount that can receive tax relief.

This amount is known as the annual allowance. If you save more than this amount you may have to pay a tax charge on the excess unless you are able to bring forward unused allowances from the previous three tax years.

ANNUITY

This is an income stream purchased from a life assurance company on retirement.

When you retire you will no longer be earning a salary. If you have saved a lump sum via a pension it may (but doesn’t have to) be converted into an annuity to provide you with an income in retirement. Note that some annuities die with you and may have no value to anyone else after death.

ARBITRAGE

In financial markets small pricing anomalies can arise which some traders like to exploit.

These are called arbitrage opportunities. For example, the same contract might briefly be priced slightly differently in two parts of the global market. A trader will buy the contract in the market where it is cheap and sell it where is pricier and take the difference as a small profit. As the gains available in this situation are usually tiny most arbitrageurs employ leverage (they borrow heavily) to magnify them.

ASSET CLASS

A general term used to describe very broad investment categories.

Typical asset classes could include cash, property and shares. The first step in diversifying wealth is to ensure that it is spread across different asset classes.

AUDITOR

It is a legal requirement that most companies have their accounts certified as being “true and fair” and prepared in accordance with the relevant legislation.

This is the job of an auditor. The job is typically done by a firm of accountants appointed by the firm with the report that they prepare being sent to its shareholders as part of the annual report and accounts.

S

SELF-ASSESSMENT

Once you meet certain criteria, you are expected to fill in a tax return every year.

SENTIMENT INDICATOR

One way to try and assess which way stock prices will move is via a sentiment indicator.

SHARE

This is the mechanism by which firms raise capital from investors willing to take an equity stake in a business and share directly in its fortunes.

SHARE BUYBACK

Firms with excess cash may opt to return it to shareholders by offering to buy back existing shares in the open market.

SHARPE RATIO

This is one way to try and capture how a fund’s return compares to its risk profile.

SHORTING

Most investors buy shares in the hope that they will rise in value – as such they are said to be “long”.

SMALL CAP

This is the name given to small shares often of a certain size in market capitalisation (equity value) terms – generally they are worth between £1m and £100m.

SPREAD

This is a word that can be used in a number of different contexts but essentially its meaning can be summed up as “gap”..

SPREAD BET

This is a risky way for an investor to bet on the price of a security rising or falling without ever having to buy or sell the security itself.

SSAS

This is short for Small Self-Administered Scheme.

STAMP DUTY

STANDARD DEVIATION

This is a way of measuring risk.

STOP LOSS

This is an instruction given to a broker that limits the fallout from a trade that goes wrong.

SWAP

This is a derivative that allows two counterparties to keep their existing assets but change their exposure.

B

BALANCE SHEET

A statement of a firm’s net worth, a balance sheet lists what the company owns (assets), what it owes (liabilities) and how it has all been financed (shareholders’ funds).

A growing balance sheet generally reflects the fact that a firm is profitable.

BANK OF ENGLAND

This is the name of Britain’s central bank tasked with several key responsibilities.

One is fiscal policy – setting the level of interest rates and also the amount of any additional monetary stimulus such as quantitative easing (QE) needed to hit its targets in relation to interest rates and the overall level of economic growth. The bank also has some regulatory responsibilities for banks and insurers. The central bank is also the lender of last resort should the banking system threaten to fail.

BASIS POINT

This is one one-hundredth (0.01%) of one percent.

So 5 basis points is equivalent to 0.05% – rather than saying 0.05% it is easier to say 5 basis points (or “bips”).

BEAR

Someone who expects prices to fall, whether for property, shares, currencies or commodities.

When this occurs on a consistent basis – and the drop is 20% or more in the case of equity markets – you get what is called a “bear market”.

BENEFICIAL SHAREHOLDER

Shares are registered instruments, meaning that a name has to be recorded on the relevant share register to reflect legal ownership.

It is common for a broker with many clients to put their own name on the register. That makes the broker the legal owner of the shares however the beneficial owner is the underlying shareholder because they will ultimately benefit from any share price growth and/or income paid by the underlying company.

BETA

This is a measure of the volatility of a portfolio, or a single stock, in relation to the wider market.

The higher a stock’s beta the more volatile, or cyclical, it tends to be. In simple terms it compares the movement in a single stock to the movement of the wider market – if a stock moves say 20% when the stock market moves 10%, it has a beta of 2 (20%/10%). In short then, a stock with a beta of 2 usually moves, based on historic data, twice the distance of the wider stock market whereas a stock with a beta of say 1 moves exactly in step with it. Defensive portfolios or stocks tend not to swing around wildly and therefore have lower betas below 1.

BID PRICE

Most prices for financial instruments are quoted “two way” – there is a bid and an offer price.

The price at which you can sell securities in the market is the bid price for your counterparty. So if a share has a spread of 210p-215p, 210p is the more relevant price when it comes to selling shares.

BITCOIN

A virtual asset built on the Blockchain distributed ledger.

Labelled a “currency”, Bitcoin may be used to buy a limited range of goods and services and can be exchanged for other virtual currencies as well as hard currencies such as the US dollar (subject to restrictions). Its main use to date, however, has been as a means of speculating on the potential value of the underlying technology. Both Bitcoin and the market in which it operates are unregulated, which makes it highly risky as an investment.

BLUE CHIP STOCK

A high quality well established company is said to be blue chip.

Typically its shares will be quoted on the main market of the London Stock Exchange.

BOND YIELD

Investors buy bonds looking for an annual return known as a yield.

There are two basic types – an income yield only takes account of the annual income a bond generates as a percentage of the current price. A yield to maturity also factors in any expected annual capital gain or loss between the point of purchase and the point the bond is redeemed by the issuer. See also redemption yield and net redemption yield.

BONUS ISSUE

One way for a UK firm to reduce its average share price is via a bonus issue.

Here a firm gives away free shares in a fixed ratio based on a shareholder’s existing holding. So for example a 1-for-4 bonus issue when the current price is £2.50 results in a shareholder receiving one free share for every four currently held. If you were the holder of 800 shares before the bonus issue, priced at £2.50 each your holding would be worth £2,000. A 1-for-4 bonus issue would allocate you another 200 free shares. Now your total holding is 1,000 shares worth £2,000 suggesting a new “ex-bonus” price of £2 per share.

BOOK BUILDING

This is the process where a bank seeks support for a share transaction from typically institutional clients.

So ahead of an IPO for example, where the bank needs to guarantee buyers for a firm’s shares when they are first sold, the bank will approach fund managers and ask for a commitment to buy. This is known as book building. The aim is to get a firm commitment for all of the shares on offer.

BOOK VALUE

Firms are required to record assets and liabilities in a balance sheet at the point they are acquired or taken on.

The sum of a firm’s “book” assets, net of outstanding liabilities, is known as its net asset value. This can also be referred to as the firm’s total book value. It won’t necessarily be the same as a firm’s market value because assets and liabilities recorded in the book are not always kept up to date and there are valuable assets, such as a firm’s brand value, that are not recorded at all. That’s why a firm may be said to be trading at a premium to its book (its market value is above its book value) or a discount (the opposite).

BREAKEVEN POINT

This is the point where a particular deal leaves you with no overall profit or loss once all costs are factored in.

So if for example you buy a share for £2.50 and pay costs and commission of 5p, your breakeven point is £2.55 since at that price you could sell the share and recover all your costs (ignoring selling costs). If you buy a call option your breakeven point is the fixed strike plus any premium paid plus costs. With a put option it is the strike price minus any premium paid. So for example if a call option has a strike price of £2.50 and you have paid a premium of 20p per share with transaction costs of 5p per share the underlying share price will need to hit £2.75 (£2.50 + 20p + 5p) before you breakeven by exercising the option.

BRICS

This is the acronym used as a short way to describe Brazil, Russia, India and China.

These countries (along with South Africa) were once identified as the leaders in emerging markets growth however their recent performance has been mixed.

BULL

Someone who expects prices, whether for shares, property, currencies or commodities, to rise.

When prices do rise consistently, it is referred to as a “bull market”.

BUSINESS CYCLE

Lasting around ten years or so historically in the UK, a business cycle is thought to be a consequence of the way businesses and investors interact.

There are two basic economic phases – expansion and contraction – and one inevitably leads to the other, according to traditional economics. For example, when confidence is rising, businesses tend to invest to meet rising consumer demand and the economy grows. However, after a shock such as a financial crisis, the reverse trends are observed as confidence wanes and growth slows. Deciding where we are in a given cycle is therefore important in terms of an investor’s asset allocation and the extent to which, for example, they are exposed to “growth” as opposed to “value” themes and assets.

BUSINESS RELIEF

Formerly known as business property relief, business relief (BR) is a way to potentially remove qualifying assets from the scope of inheritance tax on death.

Only certain assets qualify and must usually have been held for a minimum of two years before death. It can be particularly useful for investors who hold AIM shares as a number of these may meet the criteria for BR.

T

TAPER

This is the process by which the Federal Reserve winds down its bond buying program in the US.

TAX RELIEF

Whenever you are able to offset an item of expenditure, or a cost, against income or profits in order to reduce the total amount of tax you will pay it is described as tax relief..

TECHNICAL ANALYSIS

A word used in the context of charting, technical analysis is the opposite of fundamental analysis – the study of firms from the bottom up. Instead fans of technical analysis believe that the price trend is all that counts so as an investor you should look for a strong price trend and invest accordingly as quickly as possible regardless of the fundamentals (such as a p/e ratio).

TOTAL EXPENSE RATIO

This is a useful way to compare the cost of two different funds.

TREASURY

This is the nearest US equivalent to a UK gilt.

TRUST

This is a vehicle that can help families to protect assets and also pass them on tax-efficiently.

TURNOVER

This is used in different contexts.

C

CALL ON CAPITAL

Throughout our lives, we will all have specific milestones that we need to fund, whether school fees, paying off a mortgage or even buying a second property.

These create future “calls on capital” as they will require sufficient liquid funds to be available to meet them. Part of successful planning is to identify and value these milestones so that an investment portfolio can be correctly allocated, between stocks, bonds and cash, to meet them as they arise without sacrificing long-term growth in the process.

CALL OPTION

A contract that gives the person who buys it (the “holder”) the right, but not the obligation, to buy an asset (perhaps 1,000 shares) at a fixed price (“the strike”) on or before a specified date.

The further the price of the asset is above the strike price at the point the option is exercised, the higher the potential profit for the holder. However in return for granting the option the seller (the “writer”) will demand a non-refundable sum (“the premium”) which is paid whether the option is used (“exercised”) or not.

CALLABLE BOND

With a put option it is the strike price minus any premium paid.

So for example if a call option has a strike price of £2.50 and you have paid a premium of 20p per share with transaction costs of 5p per share the underlying share price will need to hit £2.75 (£2.50 + 20p + 5p) before you breakeven by exercising the option.

CAPITAL ADEQUACY

Regulated firms such as banks are required to hold a minimum amount of capital as a rainy day fund in the hope that it stops them going bust too easily.

Regulators set the level of this minimum capital and impose various “capital adequacy” tests that firms have to pass. A typical test might involve comparing the value of a firm’s “own funds” to its risk-weighted assets to ensure it is adequately cushioned should its asset base suddenly become threatened by third party defaults.

CAPITAL GAINS TAX

This is the tax charged when a UK individual makes a chargeable disposal, via a sale or gift, of a chargeable asset (certain assets such as your main home are exempt).

The tax is charged on any gain that arises between purchase and sale at a rate that varies according to that individual’s income tax bracket.

CARRY TRADE

This is where an investor borrows in a currency where the interest rate is low and reinvests the proceeds in a currency where a higher rate of interest is available.

The difference between the interest being paid and earned is taken as a profit. The trade works as long as the currency of the loan doesn’t suddenly appreciate, which in effect boosts the outstanding amount owed.

CASH FLOW

Cash flow is the difference between the amount a firm receives in cash in a given period and the amount it spends in cash over the same period.

It can be measured in a number of ways. Free cash flow for example is a firm’s operating cash flow after certain non-discretionary cash flows, such as bank interest, tax and the amount needed to maintain fixed assets, have been deducted. Cash flow is different to profit in that it is based only on cash received and paid during a specified period rather than revenue earned or expenses incurred.

CASH FLOW STATEMENT

A financial statement that summarises the amount of cash that a business has generated less the amount spent over a twelve month period.

The statement generally breaks cash flows down into three broad categories – operating cash flows, financing cash flows and investing cash flows.

CHARGEABLE LIFETIME TRANSFER

This phrase covers transfers of value (gifts typically) that are immediately chargeable to inheritance tax unless they qualify as an exempt transfer or a potentially exempt transfer.

Typical examples include gifts to children and to certain types of trust, including discretionary trusts.

CHARTING

Some investors believe that the best way to spot where shares will head next is to look for repeating patterns based on their recent share price history.

This approach is based on the idea that history tends to repeat itself meaning that you can predict how investors, and therefore share prices, will behave. Chartists give names to these repeating patterns (for example “head and shoulders”).

CHILD TRUST FUND

A Child Trust Fund is a long-term tax-free savings account for a child if they were born between 1 September 2002 and 2 January 2011 and were living in the UK.

They have now been replaced by Junior ISAs (see JISA) for new applicants. Under the new JISA rules you can invest up to £4,128 a year and that money will then attract no income or capital gains tax subsequently. However money transferred to a JISA cannot be withdrawn until the child reaches 18 and then it all belongs to the child.

CLEARING HOUSE

Once a buyer and seller have agreed a deal, clearing is the process that ensures neither of them defaults while they are organising settlement of the trade – the point where cash moves from the buyer to the seller and the relevant securities move in the other direction.

Clearing houses take responsibility for ensuring that multiple trades in shares, bonds and derivatives can be settled on time. To encourage both parties to a trade to hit the settlement deadline, a clearing house will take a form of safety deposit from each party. This is known as margin.

CLOSED ENDED FUND

See investment trust. A closed ended fund is one that cannot issue further securities to investors to meet demand (in that sense it is not “open ended”) and does not buy them directly back when investor wish to sell.

Instead a fixed number of shares are traded between investors on a public exchange.

COLLECTIVE INVESTMENT SCHEME

This term describes an investment vehicle that pools the funds of many investors together and invests them collectively via a fund manager.

Unit trusts, investment trusts and exchange traded funds are all examples of collective investment schemes.

COMPOUND INTEREST

Compound interest is the ability to earn interest on interest.

So for example if you invest £1,000 at 10%, after one year you will have £1,100 (£1,000 x 1.1). After two years you will have £1,210 (£1,100 x 1.1). If you stay invested like this for ten years you will have £2,593, or nearly 2.6 times your original investment. The longer you invest for and the more risk you take the better your chances of a high return from compounding. However it is also effective even at relatively low interest rates especially if you can shelter any gains you make from tax using an ISA or a SIPP.

CONSUMER PRICES INDEX (CPI)

This is a standard measure of inflation that has been adopted across Europe.

The US inflation measure goes by the same name. It measures the change in prices of a standard basket of goods consumed by a typical family over a month. It matters because many payments made to savers and pensioners may be linked to it (or another inflation measure known as the retail price index) and central banks often base their interest rate decisions, in part, on the level of this index. The CPI measure the cost of regular items of expenditure such as food, utilities and petrol but does not include property related costs such as mortgage interest and council tax.

CONTRACT FOR DIFFERENCE

This is a derivative contract that enables an investor to bet on the price of an asset rising or falling without having to own the underlying asset.

As the name suggests any payment made from one party to another is simply based on the difference in price of the asset when the contract is opened compared to when it is closed. These are also known as CFDs and, unlike spread bets, any gains are taxable.

CONTRARIAN INVESTOR

This is someone who believes that the market sometimes misprices shares and leave opportunities for anyone prepared to not follow the herd.

They look for shares that are overlooked by mainstream analysts and therefore cheap or have been pushed too high and are therefore expensive. They then do the opposite of most investors and buy unpopular stocks and dump very popular ones. It’s a potentially profitable approach for anyone with the time and the talent to attempt to “beat the market” but it can also be risky – contrarians have, for example, been calling an end to London’s property boom for the last fifteen years and missed out on some big gains in the meantime.

CONVERSION RIGHTS

Some bonds are issued in convertible form which means they can be swapped for shares of the same company at a future date.

The holder of a convertible bond therefore has conversion rights. These may not be exercisable until a future date, or perhaps a series of future dates. Also the conversion will be done at a predetermined conversion ratio whereby a certain nominal value of a particular bond can be swapped for a specified number of shares at a set conversion price.

CONVERTIBLE BOND

A bond that may be converted into the shares of a firm at a predetermined date, or series of dates, in the future.

These are often issued by companies looking to pay a lower rate of interest on their debt by offering conversion rights later. The holder of the bond can expect a windfall should the firm’s shares trade higher than the fixed conversion price on the date of conversion.

CORRELATION

This is the extent to which the change in the price of two assets can be said to be related.

A high degree of correlation means that a movement in one asset, say the Dow Jones, is matched by a movement in the other, say the FTSE 100. This can be measured using “correlation coefficients”. Assets or prices that tend to move in the same direction have positive correlation, those that move in opposite directions have negative correlation.

COST OF CAPITAL

Most firms are financed by a mixture of debt, say from banks and bondholders, and equity from shareholders.

These come at different costs. A firm’s average cost of capital will lie somewhere between those two costs and represents the cost of deploying a pound in the business. Let’s say a firm’s debt costs 4% a year and its equity 8% and it is financed using £100m of each. Its weighted average cost of capital is around 6% ((4%+8%)/2). The higher this is the bigger the return on capital the firm must earn to justify staying in business. If this firm earns say 12% on its capital employed then all is well but if it can consistently only earn say 2% then it is a wealth destroyer.

COURT OF PROTECTION

This court makes decisions on behalf of people who are unable to on their own and who have not granted power of attorney to someone who can act on their behalf.

COVERED CALL STRATEGY

This is one way that a fund manager can try to enhance the income in a fund.

It works by them writing call options (the right to buy) on the shares that they hold within a portfolio. The logic is that the premium income generated boosts the overall income of the fund if the option is not exercised. The downside is that the underlying shares may have to be delivered to the holder of the call option if it is. As such, covered calls are viewed as somewhat bearish as the normal expectation is that they will not be used once written.

CREDIT DEFAULT SWAP

This is a contract that allows someone like a fund manager to in effect insure an asset – say a bond – against default.

This may be preferable to selling the bond if it is illiquid and/or difficult to replace later and/or may trigger a tax liability on sale. The fund manager pays a premium to a bank which is non-refundable provided there is no “credit event” that affects the recoverability of the bond’s cash flows. If such an event takes place the bank is obliged to compensate the fund manager (the CDS buyer).

CREDIT RATING

Credit rating agencies, such as Standard & Poor’s, Moody’s and Fitch assign ratings to bonds to reflect the risk that the issuer will be unable to meet its debt obligations.

Essentially, the ratings fall within two broad categories; investment grade and non-investment grade (also called sub-investment grade). For example, bonds with a Standard and Poor’s rating of ‘BBB-‘ or above are considered “investment grade” and issues with ratings lower than ‘BBB-‘ are called “sub-investment grade”. An issue rated ‘AAA’ is regarded as having the lowest default risk.

CREDIT SPREAD

One way to measure risk with a fixed income security is to look at the gap between the yield to maturity offered by a corporate fixed income security and that offered by a government security with a similar maturity – gilts in the UK and Treasuries in the US.

For example if a corporate bond has a yield of 4.5% and the ten-year gilt yield is 2%, the spread is 2.5% (4.5%-2%) or 250 basis points (one basis point is 0.01%). The bigger this gap, or spread, the higher the market perception regarding the riskiness of the underlying security.

CREST MEMBER

Crest is the settlement system, owned by Euroclear that is responsible for the legal transfer of securities from a seller to a buyer.

Brokers are members of CREST but a client can also apply to become one separately. This means that they can legally hold shares in their own name rather than that of their broker.

CUSTODY

This can be summarised as the safeguarding of a client’s assets.

Shares, for example, are registered securities, just like property, so it is important that the right legal owner ends up on the right register at the right time. With shares this can all be done electronically however with bearer securities, such as Eurobonds, the custodian may handle physical safekeeping too. Aside from safekeeping securities a custodian may also offer other services such as settlement (ensuring the right number of securities is legally registered in the relevant account at the right time), tax support, foreign exchange management and dividend and/or interest receipts and payments. Finally a custodian will typically manage corporate actions (share buybacks or splits) on behalf of its clients.

CYCLICAL STOCK

These are stocks that tend to be strongly affected by the business cycle.

So when consumers are feeling confidant they use a lot more of this type of firm’s goods or services which pushes up profits and the share price. However in bad times the same consumers will rein in spending quickly which in turn hits profits and dents the share price. Examples of cyclical firms therefore include banks (lending is often based heavily on confidence) and house builders (who only tend to build when forward orders look strong).

CYCLICALLY ADJUSTED P/E RATIO (CAPE)

A standard P/E ratio compares the current share price of a firm to one year’s earnings.

Critics argue that this makes the ratio too sensitive to the changes in a firm’s profits that can occur at different points in a ten-year business cycle. So a CAPE compares the current share price to a profit figure that is an average of the last ten years. Fans argue that this smooths out earnings volatility and makes the resulting P/E ratio more reliable. This measure is also known as the Shiller P/E after the Nobel Prize winning Yale Professor Robert Shiller, who invented it.

U

UNDERWRITING

Investment banks can earn fees not just from advising on the timing, pricing and marketing of a new share issue but also from underwriting the whole thing.

UNIT TRUST

Unit trusts are open ended investment vehicles set up to make money on behalf of investors.

UNREGULATED COLLECTIVE INVESTMENT SCHEME

This is a collective investment scheme that does not have authorisation from the FCA.

D

DEBT TO EQUITY RATIO

Also known as gearing or leverage, this is the relationship between a firm’s total interest-bearing debt and its total equity, expressed as balance sheet debt plus equity (shareholders’ funds).

So for example if a firm has £100m of interest-bearing debt and £400m of equity the debt to equity ratio is (£100m/(£100m+£400m)), or 20%. The higher this number the riskier the firm although it also means it will make a higher return for shareholders when times are good. For that reason high debt to equity firms generally have more volatile share prices than their less indebted peers.

DEFENSIVE STOCK

These are shares in sectors that tend to be in demand regardless of the economic climate.

For example we all need water, electricity and gas whether we are feeling rich or poor so utility companies tend to be labelled defensive. Equally most people don’t change their smoking habits to match their income – they smoke regardless – so tobacco stocks usually go into the same category. Typically defensive stocks are not fast growers in earnings terms, and therefore tend to attract lower price to earnings ratios than their more cyclical peers subject to where we are in the business cycle.  However they are often generous dividend payers as they usually enjoy strong, steady cash flow.

DEFICIT

If a country exports less in terms of goods and services than it imports, it is said to run a deficit.

A classic example is the UK economy. China on the other hand usually exports more than it imports and runs a surplus as a result. The nature of international trade means that some countries will be running deficits and some surpluses at any given point in time.

DEFINED BENEFIT PENSION

Also known as final, or average, salary schemes, these arrangements offer many employees of the state and some larger companies a pension based on their salary whilst in employment.

For example you might accrue one eightieth of your final salary for every year that you work up to a maximum of 40/80ths based on forty years at work with that employer. This takes away the pension risk from an employee – who knows exactly what they will be entitled to under this type of arrangement – and places it on an employer who must ensure the pension scheme is sufficiently well funded to meet its obligations.

DEFINED CONTRIBUTION PENSION

Also known as money purchase schemes, these are a way of building up a private pension fund.

An employee and an employer can both contribute with the contribution from an employer typically being a fixed percentage of the employee’s salary. Contributions into a money purchase pension receive tax relief at the employee’s marginal income tax rate. On retirement, the resulting pot may be turned into an income, usually by buying an annuity or may be left invested to take advantage of the income and capital drawdown rules. Since contributions into a money purchase scheme are invested, the size of the pension pot generated for a retiree is dependent on investment performance.

DEFLATION

In a growing economy investors normally expect to see inflation – rising prices.

However when economic growth stalls the opposite is possible – deflation. This is where the overall cost of a typical basket of goods and services, measured in the US and Europe using the Consumer Prices Index, drops. This might sound like a good thing on the face of it as it means the average family is paying less to buy what it needs each month. However in reality it is anything but – it puts downward pressure on wages and discourages spending as people start to expect to buy things more cheaply by simply waiting. Delayed spending is bad news for firms’ profits expectations and ultimately jobs.

DELEVERAGING

Firms and other organisations that carry a lot of debt funding are said to be leveraged.

It means they are quite exposed if their cost of borrowing increases. At times of financial stress these firms have to find a way to reduce their exposure to debt and this process is known as deleveraging. When this involves selling assets in order to raise the cash they need to pay down debt this can be tough as in a slow market it may not be easy to offload assets at the right price. Deleveraging can also be triggered by regulators changing their capital requirements and forcing firms to take on less risk.

DEPRECIATION

If a firm acquires a big asset such as a factory, it will expect to use it for many years to help it to generate revenue.

The question then arises as to how to treat the initial cost, say £1m. Depreciation is the process whereby the cost of the asset is spread over the years the firm hopes to use the factory to generate sales. So, for example, if that period is 20 years, profits will take a charge each year of about £50,000 (£1m/20). That cost is known as a depreciation charge. It is thought to give a fairer view of how the asset is being used than simply writing off the whole cost against profits in the year that it is acquired.

DERIVATIVE

In very simple terms a derivative is an instrument that derives its value from another one.

There are three basic types – the future, the option and the swap. These tend to be used by mainly institutional clients. For a retail investor the nearest thing to a future is a spread bet. This allows you to place up and down bets on assets such as shares or commodities without having to own, or pay for, the underlying assets. Indeed often the amount of cash that you commit to a derivative position is a relatively small proportion of the value of the underlying asset. In this sense derivative positions are “geared” – big profits and losses can be generated from small initial investments. For this reason they can be dangerous for novice investors.

DEVELOPED MARKETS

These are mature, typically western, markets that are expected to grow at modest rates and offer reasonable security to investors.

Examples include the US, the UK, Europe and Japan. Developing markets on the other hand are those that are growing faster but from a lower base. As such they offer greater growth rates but also higher investment risk.

DISCOUNT RATE

One pound today is worth one pound. But what is one pound received in one year worth now?

The answer depends on interest rates in the meantime. If interest rates are 10% one pound now could be invested to earn 10p over a year so that pound – which will be worth 110p – is more valuable than one pound received in a year’s time. To compare the value of the later pound with the pound now in today’s terms you need to reduce it by a discount rate of 10%. The sum is £1/1.1 which is more like 91p. In other words a pound received in a year’s time is worth less, in today’s terms, than £1 received now.

DISCRETIONARY STOCKBROKING

Here a broker has the power to help you create a tailored portfolio and to make investment decisions on your behalf.

Investors who don’t have the time, inclination or expertise to make their own investment decisions often use a discretionary service.

DISCRETIONARY TRUST

This is a type of trust where the trustees have a choice (discretion) about how to use the income of the trust and sometimes the capital too.

Typical holdings within these trusts can include cash, land or buildings and other investments. The reasons for setting one up vary but examples would include wanting to set aside capital for grandchildren that may need assistance later in life or wanting to help a beneficiary who may not be capable of looking after themselves. A trust may also be useful as a way of gifting assets to children for inheritance tax purposes, however, since the rules around this have tightened in recent years, you should seek advice to make sure the trust is structured both to meet the wishes of the settlor and comply with the rules.

DIVIDEND

Firms that make profits have two choices – they can either keep them and reinvest them in the hope of making more profits or pay them out to shareholders as a dividend.

Let’s say a firm makes profits of 10p per share, it might decide to pay out 2p per share as a dividend. This is cash paid directly to shareholders. The remaining 8p per share is reinvested in the business. For investors seeking regular income, dividend paying shares are better bets than non-dividend payers. The latter are known as growth shares and are higher risk in the sense that a shareholder’s gains all come from share price appreciation. There are two types of dividend – ordinary and preference – however ordinary dividends, which are determined by the directors each year, are the more common. Note that UK dividends are paid net of standard rate tax, so a 3.6% dividend yield is equivalent to 4.5% when stated gross (before basic rate tax).

DIVIDEND COVER

An important question for a shareholder relying on dividends is whether a firm will be able to afford to carry on paying them in the future.

One measure of this is dividend cover. This is the number of times the profit available to pay a dividend actually covers the dividend paid. So for example if profit after tax is £100m and a firm’s annual dividend is £10m the dividend is covered 10 times (£100m/£10m). The higher this number the more comfort an investor has about dividend affordability.

DIVIDEND YIELD

If you own an income stock you want to know what annual return you are making. Enter the dividend yield.

This is a firm’s annual dividend as a percentage of the current share price. So if the annual dividend is 10p per share and the share price is £1, the yield is 10% ((10p/£1) x 100%). This can be compared to the income return on other investments such as fixed income securities and even cash accounts. Be careful though – sometimes a high yield is a function of a low share price which suggests investors may be nervous about the sustainability of the dividend. This situation is known as a dividend trap.

DOMICILE

This is your permanent legal home for tax purposes.

It is usually the country you were born in or the one where your parents spent most of their time if that was not the country of your birth. It matters because, amongst other things, it is a key determinant of how you will be taxed and on what basis.

DURATION

This captures the sensitivity of the price of a fixed income security to a change in interest rates, all in one number.

Two of the factors that influence bond prices are general interest rates and the time remaining until the security is redeemed, or bought back. A security with a high duration is usually more sensitive in price terms to changes in interest rates than one with a lower duration. As a rough rule of thumb the lower the coupon rate on the security and the longer it has to run until maturity, the higher the duration number will tend to be. Note that for a particular bond duration is not fixed and it decreases as the bond moves towards maturity.

V

VENTURE CAPITAL TRUST

This is a vehicle that allows investors to back fast growing, early stage companies via a trust structure that is listed on the London Stock Exchange.

VIX

An index, created by the Chicago Board of Trade, to measure volatility.

VOLATILITY

This is the extent to which an asset prices rises and falls and also the speed with which it does so.

VWAP

This is short for volume weighted average price. It is, as the name suggests, the average price weighted by volume.

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Disclaimer

Please remember that we are an investment company and as is the very nature of investing, there are inherent risks. The value of your investments can both rise and fall over time and you cannot assume that past performance will repeat itself. You must be comfortable in the knowledge that you may receive less than you originally invested. The tax treatment of your investments with Killik & Co will depend entirely on your individual circumstances and may be subject to change, so please do seek advice.

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© 2018 Killik & Co. All rights reserved. Killik & Co LLP is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales No. OC325132 at 46 Grosvenor Street, London, W1K 3HN. A list of partners is available to view here.
© 2018 Killik & Co. All rights reserved. Killik & Co LLP is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales No. OC325132 at 46 Grosvenor Street, London, W1K 3HN. A list of partners is available to view here.
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