Financial Glossary

Absolute Return Strategies
Investment strategies looking for consistent, positive returns as opposed to relative return strategies, which offer the prospects of returns that vary according to general market conditions. The simplest of all absolute return strategies, cash, delivers a constant, pre-agreed return for a given period of time.

Active Return
The portfolio's return above the return of the benchmark.

Active Risk
The volatility of the portfolio's active return.

Alpha
Measures risk-adjusted returns over and above what an index portfolio may provide. Alpha is usually generated through selecting individual securities that outperform, but Alpha may also be generated through for example market timing.

Alternative Investment Strategies
There are many different definitions of “Alternative Investments” in circulation. We subscribe to one of the broadest possible definitions, i.e. any investment strategy that is not either cash, (long only) fixed income or (long only) equities. This would include asset classes such as commodities, foreign exchange, real estate, private equity, venture capital and all categories of hedge funds and funds of hedge funds (see also “Traditional Investment Strategies”).

Asset Allocation
A systematic allocation of the client’s assets across asset classes with the objective of maximising returns for the amount of risk taken.

Asset Class
A grouping of corresponding types of securities related in appearance, although not identical, which respond in similar fashion to changes in economic climate, etc. (e.g. European equities).

Benchmark
A measure against which the investment manager is going to measure himself. A benchmark is either relative (e.g. a stock market index) or absolute (e.g. the risk-free rate of return). It is the objective of the investment manager to outperform the benchmark.

Best of Breed
Few active managers outperform their benchmarks consistently, but a few do, at least most years. A “Best of Breed” approach selects those managers who have a truly remarkable track record. See also “Open Architecture”.

Black Box Managers
An expression used to describe those investment managers who do not reveal their investment strategy to the public.

Beta
A quantitative measure of the volatility of a given stock or portfolio of stocks, relative to the overall market (e.g. the S&P 500). A beta above 1 is more volatile than the overall market, while a beta below 1 is less volatile.

Cap (Large & Small)
Cap ~ Capitalization. Equals market value. Stocks are usually divided into large cap and small cap stocks. The definition varies from market to market (and from observer to observer). In the U.S., for example, stocks with a capitalization of less than $5 billion are usually considered small cap.

Capital Asset Pricing Model
CAPM. An economic model for valuing stocks by relating risk and expected return. Based on the idea that investors demand additional expected return (called the risk premium) if asked to accept additional risk.

Capital Preservation
The protection of investors’ capital regardless of market conditions.

Convertible Bond
A corporate bond, usually a junior debenture, that can be exchanged, at the option of the holder, for a specific number of shares of the company's preferred stock or common stock. Convertibility affects the performance of the bond in certain ways. First and foremost, convertible bonds tend to have lower interest rates than non-convertibles because they also accrue value as the price of the underlying stock rises. In this way, convertible bonds offer some of the benefits of both stocks and bonds. Convertibles earn interest even when the stock is trading down or sideways, but when the stock price rises, the value of the convertible increases. Therefore, convertibles can offer protection against a decline in stock price. Because they are sold at a premium over the price of the stock, convertibles should be expected to earn that premium back in the first three or four years after purchase. In some cases, convertibles may be callable, at which point the yield will cease.

Correlation (in this context)
The degree to which the fluctuations of one numerically valued variable are similar to those of another.

Correlation Coefficient
Measures the correlation between two (or more) variables. –1 indicates perfect negative correlation (i.e. opposite trends); 0 indicates no correlation (i.e. no relationship whatsoever), and +1 indicates perfect positive correlation (i.e. the two variables move in tandem).

Delta
The change in price of a call option for every one point move in the price of the underlying security. Also called hedge ratio.

Derivative
A financial instrument whose characteristics and value depend upon the characteristics and value of an underlying security, typically a commodity, bond, equity or currency. Examples of derivatives include futures and options. Investors sometimes purchase or sell derivatives to manage the risk associated with the underlying security, to protect against fluctuations in value, or to profit from periods of inactivity or decline. These techniques can be quite complicated and quite risky.

Efficient Frontier
A set of portfolio allocations that delivers the highest possible return for a given amount of standard deviation (risk). In other words, for each level of risk there is a corresponding portfolio composition that maximises expected returns. The efficient frontier is the combination of all of these portfolios.

Efficient Market Theory
The (now largely discredited) theory that all market participants receive and act on all of the relevant information as soon as it becomes available. If this were strictly true, no investment strategy would be better than a coin toss. Proponents of the efficient market theory believe that there is perfect information in the stock market. This means that whatever information is available about a stock to one investor is available to all investors (except, of course, insider information, but trading on insider information is illegal). Since everyone has the same information about a stock, the price of a stock should reflect the knowledge and expectations of all investors. The bottom line is that an investor should not be able to beat the market since there is no way for him/her to know something about a stock that isn’t already reflected in the stock's price. Proponents of this theory do not try to pick stocks that are going to be winners; instead, they simply try to match the market's performance. However, there is ample evidence to dispute the basic claims of this theory, and most investors don't believe it.

Expected Returns
The model used in our investment approach requires projections on future returns. These estimates are called expected returns. Although estimates for each of the asset classes are subject to a great deal of uncertainty in the short run, once combined, the uncertainty is reduced significantly through diversification, as projections on some asset classes are undoubtedly too optimistic, whereas, on others, estimates turn out to be overly pessimistic. By using very long time-series (30-40 years or longer) as the basis for one’s estimates, the estimates become fairly reliable.

FSA
Financial Services Authority. The UK’s single statutory regulator under the "Financial Services and Markets Act" and thus the regulator of exchanges, clearing houses, banks and other investment houses.

Fund of Funds
A fund which invests in mutual funds or hedge funds. Just as a mutual fund or hedge fund invests in a number of different securities, a fund of funds holds shares of many different mutual funds or hedge funds. These funds were designed to achieve even greater diversification than single manager funds. On the downside, fees on funds of funds are typically higher than those on regular funds, because they include the fees charged by the underlying funds.

Futures
A standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date. Unlike options, futures convey an obligation to buy. The risk to the holder is unlimited, and because the payoff pattern is symmetrical, the risk to the seller is unlimited as well. Dollars lost and gained by each party on a futures contract are equal and opposite. In other words, futures trading is a zero-sum game. Futures contracts are forward contracts, meaning they represent a pledge to make a certain transaction at a future date. The exchange of assets occurs on the date specified in the contract. Futures are distinguished from generic forward contracts in that they contain standardized terms, trade on a formal exchange, are regulated by overseeing agencies, and are guaranteed by clearinghouses. Also, in order to insure that payment will occur, futures have a margin requirement that must be settled daily. Finally, by making an offsetting trade, taking delivery of goods, or arranging for an exchange of goods, futures contracts can be closed. Hedgers often trade futures for the purpose of keeping price risk in check. Also called futures contract.

Gamma
Measures the rate of change of the delta value with each increase or decrease of every dollar in the underlying product price.

Hedge
An investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security, such as an option or a short sale.

Hedge Fund
A fund, usually used by wealthy individuals and institutions, which is allowed to use aggressive strategies that are unavailable to mutual funds, including selling short, leverage, program trading, swaps, arbitrage, and derivatives. Hedge funds are exempt from many of the rules and regulations governing other mutual funds, which allows them to accomplish aggressive investing goals. As with traditional mutual funds, investors in hedge funds pay a management fee; however, hedge funds also collect a percentage of the profits (usually 20%).

High-Grade Bond
A bond with a rating of AAA or AA, the two highest ratings

Information Ratio
The ratio of active return to active risk, or the ratio of residual return to residual risk.

Jensen Index
An index that uses the capital asset pricing model to determine whether a money manager outperformed a market index.

Kurtosis
A parameter describing the peakedness and tails of a probability distribution.

Leverage/Gearing
Definition 1:The degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders' return on their investment and often there are tax advantages associated with borrowing. also called financial leverage.
Definition 2: What the debt/equity ratio measures.

LIBOR
London Inter-Bank Offer Rate; a proxy for the risk-free rate of return.

LLP
Limited Liability Partnership. Another name for a Limited Liability Company, often used by professional associations. The partner or investor's liability is limited to the amount he/she has invested in the company.

Low Grade
A bond rating of B or lower, indicating some uncertainty as to the issuer's ability to meet the bond's obligations.

Maximum Drawdown
The greatest loss that could have been experienced by an investor over the entire period.

Modern Portfolio Theory
Overall investment strategy that seeks to construct an optimal portfolio by considering the relationship between risk and return, especially as measured by alpha, beta, and R-squared. This theory recommends that the risk of a particular stock should not be looked at on a stand-alone basis, but rather in relation to how that particular stock's price varies in relation to the variation in price of the market portfolio. The theory goes on to state that given an investor's preferred level of risk, a particular portfolio can be constructed that maximizes expected return for that level of risk. also called modern investment theory.

Mean Reversion
The tendency for individual securities or entire asset classes to revert to their long-term averages after periods of relative under- or outperformance. The phenomenon that justifies the need for periodical re-balancings of portfolios.

NAV
Net Asset Value. The value of a single mutual fund share, based on the value of the underlying assets of the fund minus its liabilities, divided by the number of shares outstanding. Calculated at the end of each business day.

Normal Distribution
Also known as the Gaussian distribution (named after Carl Friedrich Gauss) or the Bell Curve because the graph depicting its probability density resembles a bell. The shape of the bell curve is defined by two key variables - the mean and the variance. The standard normal distribution is the normal distribution with a mean of zero and a variance of one. The normal distribution of returns is a central assumption in modern portfolio theory.

Open Architecture
The ability to work with independent investment managers, which allows for a “Best of Breed” approach (see “Best of Breed”).

Optimisation
The process by which the portfolio is re-balanced (see “Re-Balancing” below) in order to seek the highest possible risk-adjusted returns. The methodology used in this analysis is called mean-variance optimisation and is based on the work of the American economist Harry Markowitz.

Portfolio Turnover
The rate of trading activity in a fund's portfolio of investments, equal to the lesser of purchases or sales, for a year, divided by average total assets during that year.

Power Law Distribution
Unlike normal distributions, power law distributions do not have a well defined mean and variance. Power law distributions are characterised by a large number of small observations and a small number of very large observations. Natural disasters such as earthquakes are classical power law distributions. In financial markets, power law distributions are increasingly being used to describe return patterns.

Re-Balancing
The regularly occurring process by which the portfolio is adjusted to take into account (amongst other things) major moves between asset classes. Typically, asset classes that have enjoyed major positive moves will be reduced in size, whereas exposure to asset classes that have underperformed, may be increased.

Redemption
The return of an investor's principal in a security, such as a bond, preferred stock or mutual fund shares, at or prior to maturity.

Rho
Measures the change in options price with the increase or decrease in the risk free interest rate.

Risk
In the context of investing, risk may represent a number of uncertainties, such as volatility, opportunity risk, liquidity risk, procedural risk, fraud, etc. In the context of our work, risk would, unless specifically mentioned otherwise, represent volatility (standard deviation).

Risk-Adjusted Returns
A measure of the portfolio return per unit of risk taken (i.e. return divided by standard deviation), in order to compare returns on an apples-to-apples basis.

Risk-Free Rate of Return
The rate at which one assumes no risk when investing the capital. Usually, one, two or three months’ inter-bank rates (e.g. LIBOR) are used as proxies for the risk-free rate of return.

R Squared
R2 is a statistic that will give some information about the goodness of fit of a model. In regression, the R2 coefficient of determination is a statistical measure of how well the regression line approximates the real data points. An R2 of 1.0 indicates that the regression line perfectly fits the data.



Sharpe Ratio
A risk-adjusted measure developed by William F. Sharpe, calculated using standard deviation and excess return to determine reward per unit of risk. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.

Skewness
A statistical term used to describe a situation's asymmetry in relation to a normal distribution.

Sortino Ratio
A variation of the Sharpe ratio which differentiates harmful volatility from volatility in general using a value for downside deviation. The Sortino ratio is the excess return over risk-free rate over the downside semi-variance, so it measures the return to "bad" volatility. This ratio allows investors to assess risk in a better manner than simply looking at excess returns to total volatility, since such a measure does not consider how often the price of the security rises as opposed to how often it falls.

Standard Deviation
A statistical measure of the historical volatility of a security, portfolio of securities or asset class. It is a measure of the extent to which returns deviate from their averages. If returns follow a normal distribution (like the bell curve), 68% of all possible return values will fall within one standard deviation of the expected return. 95% equals two and 99% three standard deviations.

Strategic Asset Allocation
The name of the investment approach that Absolute Return Partners subscribes to. It is characterised by attaching no major significance to market expectations (see also “Tactical Asset Allocation”). Assets are allocated according to relative valuations, volatility, correlations, etc.

Tactical Asset Allocation
As opposed to strategic asset allocation (see above), the investor’s market expectations (i.e. his view on equities, interest rates and foreign exchange rates) determine the investment strategy when applying tactical asset allocation. Some investors use tactical asset allocation as an overlay to strategic asset allocation.

Theta
Measures the change in option price with the passing of each day. The value increases with days for at-the-money options and decreases with days for out-of-the money option.

Tracking Error
When using an indexing or any other benchmarking strategy, the amount by which the performance of the portfolio differed from that of the benchmark. In reality, no indexing strategy can perfectly match the performance of the index or benchmark, and the tracking error quantifies the degree to which the strategy differed from the index or benchmark.

Traditional Investment Strategies
We consider only cash, (long only) fixed income and (long only) equities Traditional Investment Strategies, although we openly admit that there are many variations of this definition (see also “Alternative Investment Strategies”).

UCITs
The pan-European act regulating the mutual fund industry. These rules prevent regulated mutual fund managers from using leverage as well as selling short. Likewise, there are strict concentration rules in order to secure broad diversification of assets.

Vega
Measures the change in option price with the increase or decrease of volatility of the underlying asset. The value is often greater for at-the-money options than out-of-the-money options.

Vinculum
A horizontal line drawn over a group of terms to show they have a common relation to what follows or precedes.

Volatility
A measure of risk. Measures the uncertainty of the period-to-period (usually year-to-year) performance relative to the expected return. Often used interchangeably with Standard Deviation (see “Standard Deviation”).

VAR
Value At Risk. A technique which uses the statistical analysis of historical market trends and volatilities to estimate the likelihood that a given portfolio's losses will exceed a certain amount.

Yield Curve
A curve that shows the relationship between yields and maturity dates for a set of similar bonds, usually Treasuries, at a given point in time.