Glossary

Active management
The attempt to uncover securities the market has either under- or overvalued; also the attempt to time investment decisions in order to be more heavily invested when the market is rising and less so when the market is falling.

Alpha
A measure of performance against a benchmark. Positive alpha represents outperformance; negative alpha represents underperformance.

Asset allocation
The process of determining what percentage of assets should be dedicated to which specific asset classes.

Asset class
A group of assets with similar risk and reward characteristics. Cash, debt instruments, real estate, and equities are examples of asset classes. Within a general asset class, such as equities, there are more specific classes such as large and small companies and domestic and international companies.

Basis point
One one-hundredth of 1 percent, or 0.0001.

Benchmark
An appropriate standard against which actively managed funds can be judged. Actively managed large-cap growth funds should be judged against a large-cap growth index such as the S&P 500, while small-cap managers should be judged against a small-cap index such as the Russell 2000.

Book-to-market value (BtM)
The ratio of the book value per share to the market price per share, or book value divided by market capitalization.

Book value
An accounting term for the equity of a company. Equity is equal to assets less liabilities; it is often expressed in per-share terms. Book value per share is equal to equity divided by the number of shares.

Call
An option contract that gives the holder the right, but not the obligation, to buy a security at a predetermined price on a specific date (European call) or during a specific period (American call).

Churning
Excessive trading in a client’s account by a broker seeking to maximize commissions, regardless of the client’s best interests. Churning is a violation of FINRA rules and is illegal.

Correlation
In mathematics, correlation is the measure of the linear relationship between two variables. Values can range from +1.00 (perfect correlation) to -1.00 (perfect negative correlation). An example of a strong positive correlation would be stocks of two oil companies. A strong negative correlation might exist between an oil company (that benefits from rising oil prices) and an airline company (that would benefit from a fall in oil prices).

CPI
Consumer price index.

CRSP
Center for Research in Security Prices.

Distressed stocks
Stocks with high book-to-market values and/or low price-to-earnings ratios. Distressed stocks are generally considered to be value stocks.

DJIA
Dow Jones Industrial Average.

EAFE Index
The Europe, Australasia, and Far East Index, similar to the S&P 500 Index in that it consists of the stocks of the large companies from the EAFE countries. The stocks within the index are weighted by market capitalization.

Efficient market
A state in which trading systems fail to produce returns in excess of the market’s overall rate of return because everything currently knowable about a company is already incorporated into the stock price. The next piece of available information will be random as to whether it will be better or worse than the market expects. An efficient market is also one in which the trading costs are low.

Emerging markets
The capital markets of less developed countries that are beginning to develop characteristics of developed countries, such as higher per-capita income. Countries typically included in this category would be Brazil, Mexico, Thailand, and Korea.

Exchange-traded fund (ETF)
For practical purposes these act like open-ended, no-load mutual funds. Like mutual funds, they can be created to represent virtually any index or asset class. However, they are not actually mutual funds. Instead, these new vehicles represent a cross between an exchange-listed stock and an open-ended, no load-mutual fund. Like stocks (but unlike mutual funds), they trade throughout the day.

Expense ratio
The operating expenses of a fund expressed as a percentage of total assets. These expenses are subtracted from the investment performance of a fund in order to determine the net return to shareholders.

FINRA
Financial Industry Regulatory Authority.

Fundamental security analysis
The attempt to uncover mis-priced securities by focusing on predicting future earnings.

Growth stock
A stock trading, relative to the overall market, at a high price-to-earnings ratio (or at a relatively low book-to-market ratio) because the market anticipates rapid earnings growth relative to the overall market.

Hedge fund
A fund that generally has the ability to invest in a wide variety of asset classes. These funds often use leverage in an attempt to increase returns.

Index fund
A passively managed fund that seeks to replicate the performance of a particular index (such as the Wilshire 5000, the S&P 500, or the Russell 2000) by buying all the securities in that index in direct proportion to their weight by market capitalization within that index and holding them.

Initial public offering (IPO)
The first offering of a company’s stock to the public.

Institutional fund
A mutual fund that is not available to individual investors. Typical clients are pension and profit-sharing plans and endowment funds.

Leverage
The use of debt to increase the amount of assets that can be acquired, for example, to buy stock. Leverage increases the riskiness of a portfolio.

Market capitalization
The market price per share times the number of shares.

Micro cap
The smallest stocks by market capitalization: The ninth and tenth CRSP deciles. Other definitions used are the smallest 5 percent of stocks and stocks with a market capitalization of less than about $200 million.

Modern portfolio theory
A body of academic work founded on the following concepts. First markets are too efficient to allow returns in excess of the market’s overall rate of return to be achieved through trading systems. Active management is therefore counterproductive. Second, asset classes can be expected to achieve, over sustained periods, returns that are commensurate with their level of risk. Riskier asset classes, such as small companies and value companies, will produce higher returns as compensation for their higher risk. Third, diversification across asset classes can increase returns and reduce risk. For any given level of risk, a portfolio can be constructed that will produce the highest expected return. Finally, there is no right portfolio for every investor. Each investor must choose an asset allocation that results in a portfolio with an acceptable level of risk.

NASDQ or NASDAQ
The National Association of Securities Dealers (Automated) Quotations. A computerized marketplace in which securities are traded, frequently called the “over-the-counter market.”

NASDAQ-100 Index
The one hundred largest capitalization stocks on that exchange.

NAV
Net asset value.

No-load
A mutual fund that does not impose any charge for purchases or sales.

Nominal returns
Returns that have not been adjusted for the negative impact of inflation.

NYSE
New York Stock Exchange.

Passive asset class funds
Funds that buy and hold all securities within a particular asset class. The weighting of each security within the fund is typically equal to its weighting, by market capitalization, within the asset class. Each security is then typically held until it no longer fits the definition of the asset class to which the fund is seeking exposure. For example, a small company might grow into a large company and then no longer fit within the small company asset class. Fund managers may also use common sense and research to implement screens to eliminate certain securities from consideration (in an attempt to improve risk-adjusted returns). To be considered a passive fund, however, those screens cannot be based on any technical or fundamental security analysis. Examples of passive screens would be: minimum market capitalization, minimum number of years of operating history, and minimum number of market makers in the company stock.

Passive management
A buy-and-hold investment strategy, specifically contrary to active management. Characteristics of the passive management approach include: lower portfolio turnover, lower operating expenses and transaction costs, greater tax efficiency, fully invested at all times, and a long-term perspective.

P/E ratio
The ratio of price-to-earnings. Stocks with high price-to-earnings ratios are considered growth stocks; stocks with low P/E ratios are considered value stocks.

Prudent Investor Rule
A doctrine imbedded within the American legal code stating that a person responsible for the management of someone else’s assets must manage those assets in a manner appropriate to the financial circumstance and tolerance for risk of the investor.

Put
An option contract that gives the holder the right, but not the obligation, to sell a security at a predetermined price on a specific date (European put) or during a specific period (American put).

Real returns
Returns that reflect purchasing power as they are adjusted for the negative impact of inflation.

Rebalancing
The process of restoring a portfolio to its original asset allocation. Rebalancing can be accomplished either through adding newly investable funds or by selling portions of the best-performing asset classes and using the proceeds to purchase additional amounts of the underperforming asset classes.

Registered investment adviser
A designation representing that a financial consultant’s firm is registered with the appropriate state regulators and that the RIA representatives for that firm have passed the required exams.

REIT
Real estate investment trust, a trust available to investors through the purchase of shares in it.

Retail funds
Mutual funds that are sold to the general public, as opposed to institutional investors.

Risk premium
The higher expected, not guaranteed, return for accepting the possibility of a negative outcome.

Russell 1000
The largest one thousand companies within the Russell Index.

Russell 2000
The smallest two thousand of the largest three thousand stocks within the Russell Index. Generally used as a benchmark for small-cap stocks.

S&P 400 Index
A market-cap-weighted index of four hundred mid-cap stocks.

S&P 500 Index
A market-cap-weighted index of five hundred of the largest U.S. stocks designed to cover a broad and representative sampling of industries.

S&P 600 Index
A market-cap-weighted index of six hundred small-cap stocks.

SEC
Securities and Exchange Commission.

Sector Fund
A fund that restricts its investments to a single industry or sector of the economy (e.g., health care, technology).

Sharpe Ratio
A measure of the return earned above the rate of return earned on riskless short-term U.S. treasury bills relative to the risk taken, with risk being defined as standard deviation of returns. Example: The return earned on an asset was 10 percent. The rate of one-month Treasury bills was 4 percent. The standard deviation was 20 percent. The Sharpe Ratio would be equal to 10 percent minus 4 percent (6 percent) divided by 20 percent, or 0.3.

Spiders (SPDR)
Exchange-traded funds that replicate the various S&P Indices.

Standard deviation
A measure of volatility or risk. For example, given a portfolio with a 12 percent annualized return and an 11 percent standard deviation, an investor can expect that in thirteen out of twenty annual periods (about two-thirds of the time) the return on that portfolio will fall within one standard deviation, or between 1 percent (12 percent - 11 percent) and 23 percent (12 percent + 11 percent). The remaining one-third of the time an investor should expect that the annual return will fall outside the 1-23 percent range. Two standard deviations (11 percent x 2) would account for 95 percent (nineteen out of twenty) of the periods. The range of expected returns would be between – 10 percent (12 percent – 22 percent) and 34 percent (12 percent + 22 percent). The greater the standard deviation, the greater the volatility of a portfolio. Standard deviation can be measured for varying time periods, e.g., you can have a monthly standard deviation or an annualized standard deviation measuring the volatility for a given time frame.

Style drift
The moving away from the original asset allocation of a portfolio, either by the purchase of securities outside the particular asset class a fund represents or by not rebalancing to adjust for significant differences in performance of the various asset classes within a portfolio.

Three-factor model
Differences in stock returns are best explained by company size (market capitalization) and price (book-to-market [BtM] ratio) characteristics. Taken together, research has shown that the three factors on average explain more than 96 percent of the performance of diversified stock portfolios.

TIPS (Treasury Inflation – Protection Security)
A bond that receives a fixed stated rate of return, but also increases its principal by the changes in the consumer price index. Its fixed interest payment is calculated on the inflated principal, which is eventually repaid at maturity.

Tracking error
The amount by which the performance of a fund differs from the appropriate index or benchmark. More generally, when referring to a whole portfolio, the amount by which the performance of the portfolio differs from a widely accepted benchmark such as the S&P 500 Index or the Wilshire 5000 Index.

Turnover
The trading activity of a fund as it sells securities from a portfolio and replaces them with new ones. Assume that a fund began the year with a portfolio of $100 million in various securities. If the fund sold $50 million of the original securities and replaced them with $50 million of new securities, it would have a turnover rate of 50 percent.

Value stocks
Companies that have relatively low price-to-earnings ratios or relatively high book-to-market ratios. These are considered the opposite of growth stocks.