Glossary
GLOSSARY & TERMINOLOGY: aka mini articles to help you learn how to use a term in a sentence.
12b-1 FEES:
I could take the time to look up the origin of “12b-1 fee” but the word “fee” gives it away. It is another Sales Charge! Originally 12b-1 fees were created to help brokerage firms and fund companies cover the cost of technology. There was a time when the technology to operate a fund was new and expensive. So, the mutual fund companies charged an additional fee that was rebated to the brokerage firm. The 12b-1 fee morphed into a “sales commission.” All of a sudden, a broker who sold shares of a mutual fund with 12b-1 fees would be paid the fee directly. I find this just plain offensive. Every fee costs the investor. You end up paying fee upon fee. There are no reward points for paying fees. No airline miles, no free hotel stays, nada.
ASK:
Ask means the owner of a stock is asking a specific price to sell the stock. One way to remember this definition is to think of the asker as the seller of a product.
“I am asking someone to buy my stock and pay me $10.00.”
BACK END LOAD:
Is it possible? You want to sell shares of your mutual fund and you are going to be charged yet another fee to sell. Find out before you sell. There is no reason to pay “load” fees, unless you think your advisor/broker isn’t making enough money and you are trying to help them out. Any fee you pay reduces your investment returns.
BASIS POINTS:
Knowing what a basis point is will positively influence any conversations you have with an advisor. Thinking in basis points will help you identify fees without having to ask. Understanding basis points is fundamental to knowing what your investment performance is.
Using basis points and percentages is the language of professional investors because the difference between one basis point and two basis points is a lot of money. The use of basis points lives in the “bond world” more than the stock market. If you never buy a bond, you still need to know what a basis point is.
This is how you can think about a basis point. Think of a basis point like a penny. There are 100 pennies in a dollar. There are 100 basis points in 1% (one percent equals 100 basis points). The term” basis point” is used when referring to fees. Instead of saying “half a percent,” you say “50 basis points”.
If you see 0.15% or 0.85% the translation is 15 basis points and 85 basis points.
Don’t be caught off guard by somebody who says “beeps.” BPS is the acronym for basis points. It is an inappropriate use of jargon for individual investors if not explained.
The use of basis points will become clear when we discuss fees, pricing, and investment returns.
BENCHMARK:
Investment performance is typically measured against a “benchmark.” If an investment manager says to you, “your portfolio did really well. It’s up 8%”, your question should be “but how did it do relative to the benchmark?”. The performance of your investments should always be thought of in relative terms. If the benchmark returned 10%, and your portfolio returned 8%, you want to know why your performance is 2% less. Another way to think about this is when performance is down, down into negative territory. No one likes to see a negative number but again it is all relative. If your portfolio is down 1% (- 1%) and the benchmark is down 3% (-3%), your performance is better than the benchmark by 2%. It’s a small consolation when you have a negative return.
BID:
The bidder, known as the buyer of the stock, says “I won’t pay you $10.00 but I will pay you $9.00.”
BOND PRICES:
The price of a bond changes as interest rates change. You cannot separate the two. When the Fed says they are going to raise rates it means bond prices will go down. The real question though is “how much?”
In percentage terms, you rarely see a bond price dissolve by two or three percent in a day. That is, as they say “chump change” in the stock market. Prices in the stock can change by 10% in a day. Great when prices are going up, not so great when prices are going down.
Types of Bonds include:
- Treasury Securities
- Corporate Bonds including High Yield Bonds
- Mortgage Backed Bonds
- Asset Backed Securities (student and auto loans)
- Agency Bonds: Includes government agencies like the Federal National Mortgage Association, also known as Fannie Mae. These bonds are not backed by the full faith and credit of the government.
- Bonds denominated in currencies other than dollars
- Emerging Market Bonds
BONDS:
Bonds are known as “fixed income “securities. When you buy a bond from a company (Apple for example), you are not giving your money to Apple, you are lending money to Apple. Apple is issuing bonds. Apple agrees to pay back the money they have borrowed from you with a fixed rate of income per year. If Apple fails to pay you back, you as a bondholder and a creditor of the company have recourse. You will be paid back first in a settlement. This one reason fixed income is considered less risky than equity.
The most common type of bond is a United States Treasury bond (in addition to Treasury bills and notes). When you buy a US Treasury bond you are lending money to the government. The government promises to pay you back at a specific point in the future, known as the maturity of the bond. While you are waiting to be paid back, the government will pay you a fixed, pre-determined rate of interest.
When you use a credit card, someone somewhere has decided to loan you money. Until you pay back that loan, you must pay a fixed rate of interest to the lender. Interest rates on credit cards tend to be very high. Why? Because you, the credit card user represents a risk. The risk is that you will not pay back the loan, i.e. the balance on your credit card. The bank wants to make sure they get their money back. Very high interest rates, paid by you, provide a cushion in the event you default. It is not a coincidence that bonds are also referred to as debt.
COUPON:
The coupon on a bond is the fixed rate of interest the bond will pay until the bond matures. A bond with a coupon of 3% will pay $30.00 a year on a bond issued at par ($1,000.00). Most bonds pay the coupon payment twice a year. In this example you would receive $15.00 twice a year.
CREDIT RATING:
The primary rating agencies for bonds are Moody’s and Standard and Poor’s. A credit rating is one way to measure the risk of a bond defaulting. A bond with a triple AAA rating is less likely to default than a junk bond rated C.
Bonds with a high-quality rating will pay you less in terms of a coupon than a bond with a lower credit rating. You are payed to take on more risk by receiving a higher interest payment.
EXCHANGE TRADED FUNDS:
Also known as “ETF’s.” They have nothing to do with ET the extraterrestrial although I am sure there are “outer space” ETF’s available. I find ETF’s to be one of the most complex investment “vehicles” to understand. Yes, we do refer to investments as vehicles. So unimaginative.” Sir, please step out of your vehicle,” does not sound like a tradeable security.
ETF’s are all about transparency. They do something mutual funds don’t do.
Mutual funds, as a rule, do not like to disclose exactly what stocks and bonds they own. The rational is that another investment manager could “copy” proprietary investment strategies. That might have been true 20 years ago but today it is impossible to extract an investment strategy out of a fund with thousands of individual securities.
Shares of Exchange Traded Funds trade like stock throughout the day. They are known for three things:
1. Transparency – you can see the holdings anytime
2. Low fees – in basis points! Some are as low as 5 basis points.
3. Target Markets – invest in a specific currency, country, technology, or health care. There is now an endless list of ETFs’ that provide access to specific “markets.”
What is confusing about ETF’s is how they are priced. Unlike a stock, the price of an ETF share, trades at a premium or a discount to the underlying value of the securities in the ETF. This last sentence is confusing. ETF’s are confusing. First you price every security in the fund. Then, a second price, a trading price evolves. The second price per share is either higher or lower (premium or discount) than the value of all the securities in the fund. Despite the “allure” of low fees, there is no guarantee that an ETF will provide a better return than a mutual fund with higher fees.
The Wall Street Journal had a great piece entitled “Four Reasons to Avoid the Lowest-Cost ETFs” Monday, October 9, 2017
Fees, Performance and identifying the rascally Expense Ratio are covered in an upcoming article.
EXPECTED RETURNS:
No one knows for sure what investment returns will be. That is one of the reasons you see “past performance is no guarantee of future performance” on any document that shows performance returns. When I think of expected returns it is in the context of what you as an individual expect. Is your expectation realistic? If the average annualized return of the S & P 500 for the last 10 years is 10%, is it realistic to think that the average annualized returns for the next 10 years will be 20%?
One of the most difficult challenges is managing expectations. Why? Because we only hear about the winners. If someone tells you how much money they have made on one stock, ask them how much they have lost on other stocks.
FRONT END LOAD:
Why can’t a fee be called a fee? A front-end load is a fee, also known as a Sales Charge! If your mutual fund shares have a front-end load, you will pay more than the expense ratio to buy shares of a mutual fund. Find out before you buy if there is a front-end load.
GROSS EXPENSE RATIO:
An expense ratio always refers to fees. The basis for the fees comes from the costs to run a fund company. Like many businesses, the costs include accounting, administration, legal and compliance, shareholder information and a host of other expenses. The accounting for mutual funds and exchange traded funds is notoriously complicated. When looking at fees, the number you want to focus on the is the Net Expense Ratio.
INDEX:
The word index and benchmark are used interchangeably. There are hundreds of indices and benchmarks. There are some technical differences between an index and a benchmark but for now feel free to use either word. Both benchmarks and indices provide a point of reference to help you navigate the ups and downs of the markets. Indices and benchmarks are applied to the stock market, bond markets, commodities, real estate, and currencies (and a few I left out).
MATURITY:
The maturity of a bond is a fixed date in the future when you will be re-payed the par value. Like the coupon and the par value, the maturity is fixed when the bond is first issued.
MUTUAL FUNDS:
I would like to say that mutual funds are like the proverbial kitchen sink but that wouldn’t be fair. Here is how a mutual fund works. A group of people get together over drinks one night. They come up with a brilliant idea to combine the money they have and buy stocks and bonds. They combine their money because it allows them to buy more as a group than they can buy individually. Another group of people seated at the table next to them overhears their plan. They want into the pool. The original group thinks this is okay. Why not? The more the merrier however, they do have some concerns about taking money from total strangers.
The original group forms a legal structure with something called a prospectus. Prospectus, what kind of word is that? Does anybody use it in a sentence? “I can’t see you tonight because I am engrossed in my prospectus.” The prospectus determines what the group can and cannot invest in. The” group,” now that they have multiple investors decide that calling themselves “the group” is not very professional. They now call themselves “investment managers.” And their pool of money is called a “mutual fund.”
Well, the money comes flowing in the door because the investment managers are good at picking stocks and bonds. But, how to manage this equitably? The problem of treating their investors fairly is getting unwieldy. Who owns what? If I am the first investor do I own specific stocks and bonds?
Ah Ha! Let’s do what corporations do. Let’s issue shares!! (see Stocks) Investors will buy shares that represent some fractional interest in ALL the stocks and bonds that are in the mutual fund.
NET ASSET VALUE:
Think price per share. Why can’t they just say that? Mutual funds are priced once a day. One price each day. Shares of a mutual fund do not trade like stocks where the price per share changes throughout the day. The price of a share in a mutual fund is called the Net Asset Value.
How is this used in a sentence? "The Net Asset Value of the fund is $10.00 dollars per share."
NET EXPENSE RATIO:
This is the fee that is “charged” to investors in a mutual fund or exchange traded fund. The fee is always shown as a percentage. This is why understanding basis points is important. If a net expense ratio is shown as 0.20% this is referred to as 20 basis points. On a dollar, 20 basis points is equal to 2 cents. On a $10,000 investment, 20 basis points is equal to $200 dollars.
You never write a check for fees. Fees are calculated and accrued on a daily basis by the mutual fund company. The fees are then subtracted from the assets of the fund. If you are in a low fee fund, the change in the price of a share should be so small you wouldn’t notice it. If you are in a high fee fund you may notice changes in the price of the shares. Either way, you have to take fees into account when calculating returns.
PAR VALUE:
Par value for a bond is the value of the bond when it is first issued. If you buy a bond and pay $1,000.00, that is the par value. Par value represents the amount the bond issuer repays you when the bond matures. Some bonds can be issued with a price that is below $1,000.00 (below par value) or above $1,000.00 (above par value)
SPREAD:
The word spread when used in financial transactions is the difference between the Bid and the Ask.
If the Ask is $10.00 and the Bid is $9.00 the spread is One Dollar.
Spread is used when talking about interest rates and bonds. If Bond A is paying 3.00% and Bond B is paying 4.00% the spread is 1.00%
When you hear the term “spreads widened” or “spreads narrowed” it is always referring to the DIFFERENCE between two numbers.
Spreads widen when the difference increases. Now the Ask is $11.00, and the Bid is $9.00. The spread widened to Two Dollars.
Spreads narrow when the difference decreases. Now the Ask is $9.50, and the Bid is $9.25. The spread narrowed to $0.25 cents.
STOCKS:
When a company decides to raise money, it can do so by issuing stock, also known as “shares.” When you as an individual buy shares of a company you have given the company money in exchange for “equity” in the business. Although you do not have direct equity ownership (you do not “own” any property of the company), the expectation is that the business will grow and be profitable and the price of the shares will rise. When you hear the term “equities” it means the same thing as “shares”. A common phrase is “I am invested in the equity markets.”
Some equities pay “dividends.” Dividends are a form of income to you the investor. Dividends are not guaranteed and can change at any time.
Of course, there is no guarantee that the price of shares will rise. In a worst-case scenario there is a risk that the company could fail. If the company fails, you will lose your money.
Therefore, equities are considered riskier than bonds.
TICKER SYMBOL:
A ticker symbol is not a symbol at all. It isn’t this: Ʊ or this: ƹ or any other hieroglyphic looking thing. A ticker symbol is a combination of letters. The letters are a unique identifier for a specific share of company stock, or for shares of a mutual fund or exchange traded fund. Ticker symbols can tell you in a flash exactly what you own. Once you know the ticker symbol for a fund, enter it into any browser and see what pops up.
TIME LIMITS:
Time Limits refer to the length of time your order is good. How long do you want to wait to see if you buy or sell a stock?
Day Only
Most Market Orders are Day Only. A Day Only order automatically expires at the end of the trading session, typically 4:00 pm EST.
Good Until Canceled
A Good Until Canceled Order remains open for 60 days. Sixty days is a LONG time to leave an order open. You might forget about it and then Surprise!
You don’t want surprises. Most orders will default to Day Only unless you change it.
Fill or Kill
Fill or Kill? Execution? What is going on with this language? Buying and selling stock is not as hostile as it sounds.
Fill or Kill means “Now!” You place an order to buy 100 shares. You want to buy 100 shares “Now!” If you order cannot be filled immediately, it is canceled. Fill or Kill orders are Limit Orders because you are specifying a price and the number of shares.
Immediate or Cancel
Immediate or Cancel differs from Fill or Kill in one regard only. If you enter a Fill or Kill for 100 shares, you will only accept 100 shares.
With an immediate or cancel order, you will accept a partial number of shares before canceling your order.
Immediate or Cancel orders are used with Limit Orders.
All or None
All or None orders refer to the time limit you specify. All or None orders do not require immediate execution. Seriously?
TYPES OF ORDERS:
There is specific terminology for placing an order to Buy or an Order to Sell. Using different types of orders is a way to specify how a transaction will occur.
Market Orders and Limit Orders are the most basic types of orders. I have included the definitions for Stop Orders and Stop Limit Orders because you will see the terms pop up when you place an order.
The reason this language pops up or appears in the drop-down menu is that there are many different types of investors and different types of strategies. It doesn’t mean that you need to do anything different than use the most basic Market Order or Limit Order.
Market Order:
A Market Order means you are placing an order to buy or sell shares of a company at the best price available (the market price). A Market Order guarantees “execution,” meaning you will buy the stock. A Market Order does not guarantee the price.
Buy orders will execute at the “Ask” price and Sell orders will execute at the ‘Bid” price. With a Market order, the price of the security can go up or down between the time you place the order and the time the order is executed.
Limit Order:
A Limit Order is an order to buy or sell a stock at a price you specify, or better. For example, you place a limit order to buy 100 shares at $10.00 per share, “or better”.
The term “or better” is a little deceiving because a better price when you are buying a stock is always a LOWER price. Paying $9.50 per share is better than paying $10.00.
When you enter a Limit Order, there is no guarantee that your order will be filled.
A good way to use a Limit order is to control risk when prices are volatile.
Stop Order:
A Stop Order is an order to Buy or Sell at the Market price once the stock has traded at or through the Stop price. You are going to specify the Stop price.
Buy Stops are entered above the Market price. Buy Stops are typically used with a short position.
Sell Stops are entered below the Market price. Sell Stops are used with long positions.
A Stop order does not guarantee a price.
Stop Limit Order:
If you combine a Stop Order with a Limit Order, you have a Stop Limit Order. With a Stop Limit Order, two prices are entered. The Stop price and the Limit price. It is an order comprised of a series of triggers to buy or sell.
A Stop Limit Order does not guarantee an execution.
Execution:
When I see the word “execution,” I do not immediately think of placing an order to buy or sell a stock.
Visions of Marie Antoinette notwithstanding, execution means you have placed an order to buy or sell a stock. A more common term is “traded.” When you complete a trade you either own the stock or you have sold the stock.
YIELD:
In percentage terms, yield is reflected in the coupon and the price of a bond. It is not the same as the fixed rate on a bond. Yield is the percentage you are going to be paid when the price of the bond is above or below the fixed coupon rate.
For example:
Today I bought a bond with a coupon of 2% that is yielding 3%. If a bond is yielding more than the coupon, the price of the bond will be less than par value. The bond is selling at a discount.
Today I bought a bond with a coupon of 6% that is yielding 3%. If a bond is yielding less than the coupon, the price of the bond will be higher than par value. The bond is selling at a premium.
