Active Index Investing's E-ppendix
Active Index Investing's E-ppendix
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12-b1 fees A percentage of assets paid by fund shareholders to cover marketing expenses for the fund.
Active manager A portfolio manager who attempts to improve the portfolio's risk-adjusted return relative to a benchmark, through the use of stock picking, market timing, or other strategies.
Alpha Can be expressed as a positive or negative number. Commonly known as the 'extra return' a fund manager can provide relative to the market's risk. Alpha measures the difference between actual returns and expected performance resulting from exposure to specific risk factors.
American Depository Receipts (ADRs) Certificates traded on U.S. exchanges that represent shares in a foreign company.
Arbitrage Simultaneous purchase and sale of similar instruments in different markets to take advantage of price discrepancies.
Asset allocation The diversification of investments among various assets classes - such as large-cap U.S. stocks, intermediate bonds, real estate, precious metals, etc.
Asset Class A type of investment (such as a stock, bond, or REIT) that has its own particular risk/return profile.
Authorized Participant (AP) An external broker authorized to place creation/redemption orders for ETFs.
Basis point 1/100th of a percentage point, or 0.01%. For example, 20 basis points equals 0.20%.
Basis risk When hedging, the risk associated with incorrectly matching offsetting investments.
Basis trade Type of arbitrage with the goal of profiting from pricing differences between a security and its futures contract.
Basket A collection of stocks or bonds that serves as the underlying unit for a derivative product.
Bear Market A market where prices decline. Generally, a falling market has to drop 20% before it's considered a bear market.
Benchmark An index that serves as a standard against which the performance of a fund or portfolio is measured. For example, a stock fund may be compared with the S&P500 Index to assess how it performs over time, versus this benchmark. In the same way, a bond fund may be compared to a fixed income index, such as the Lehman U.S. Aggregate Index, or iBoxx € Corporates Index.
Beta Measures the sensitivity of a fund's performance to general market movement. A higher beta denotes more risk. For example, a fund with a beta of 1.40 is expected to rise or fall 14% when the market (usually represented by an index) moves 10% in either direction.
Bid/ask spread The difference between the bid price and the asking price (or offer price) in a security transaction. If a bond is bid at $101.50 and offered at $101.75, the spread is $0.25, in price terms. Bid ask spread in bond markets is more frequently quoted in yield terms, and equates to the difference between the bid yield and ask yield. For example, if bid yield = 4.20% and ask yield = 4.15%, then the bid ask spread is 5 basis points, in yield terms. The spread narrows or widens according to supply and demand for the security being traded, and is a good indicator of a bond’s liquidity. In bond markets, where institutional investors do not normally pay an explicit commission, the bid ask spread is cost incurred when buying or selling shares of securities or funds for a portfolio. Also referred to as transaction costs or explicit costs.
Book value/ Book costThe net value at which a security is carried in a portfolio. The original cost of a security of asset in a portfolio.
Broker An agent who handles investors, orders to buy and sell securities, commodities or other property. A commission is normally charged for this service.
Bull MarketA rising market. The opposite of a Bear Market.
Calendar roll Closing a futures or options position in one contract month and opening a position on the same side of the market in a more distant month.
Call An options contract that gives the option buyer the right to buy the underlying instrument at a specified price for a certain, fixed period of time. (See also Put.)
Callable bonds Embedded call option, gives the issuer to redeem the bond before its maturity date, at a pre-determined price.
Capital Asset Pricing Model A model used to value stocks by examining the relationship between risk and expected return. Assumes that investors expect to be compensated for taking more risk through higher returns.
Capital gains Taxable profits on the sale of stocks that have increased in value.
Cash market Market for commodities where transactions are settled immediately.
Cash settlement A transaction settled in cash payment (rather than the physical delivery of a commodity) depending on profit or loss.
Circuit breaker Rules and procedures used by exchanges to slow or halt trading during market crashes.
Closed-end fund A fund with a fixed number of shares outstanding, and one which does not redeem shares the way a typical mutual fund does.
Closet index fundAn actively-managed fund that 'hugs' its benchmark index, so that investors are essentially getting an index fund (at active fees).
Commodity Trading Advisor (CTA) Person or firm registered to advise others on trading futures and options.
Covered call The selling of a call option while simultaneously holding an equivalent position in the underlying stock.
Credit Non-government bonds. The bond market is generally divided into government bonds and credit. Credit being called so, after the credit risk aspect of bonds issued by non-government entities. The credit section can be further sub-divided into more and more specific sub-groups, like agencies, supranationals, corporates, securitized, etc.
Credit rating Ratings agencies attribute credit ratings to bonds as an indicator of their general credit worthiness or quality.
Cyclical StocksShares that move with the Business Cycle; generally they advance as business conditions improve and decline when business declines.
Depository Trust Company (DTC) A corporation that facilitates transfers of securities and holds securities for member institutions.
Derivatives Securities that derive their value from another security; e.g. futures and options.
Diversify To reduce risk in a portfolio by spreading investments among a number of different bond or stock issuers or issues that are not perfectly correlated so that losses in any one bond/stock/security do not impact the whole portfolio, and may be partially offset by gains in other securities holdings.
Dividend yield Annualized rate of dividends paid on a share of stock, divided by its current share price.
Dollar-cost averaging Strategy of investing fixed amounts to a fund on a regular basis (usually monthly), regardless of the market's direction. Many investors and advisors use the strategy to enforce discipline and factor out emotions in investment decisions - forcing investors to buy when shares are low.
Duration Duration of a bond is a maturity measure that takes account not only of the redemption date but of the dates on which interest is paid and the amount of this interest. Duration is an important measure of the interest rate exposure of a fixed interes portfolio.
Dynamic Hedging This is a process by which a fund's exposure to a risky market (e.g. equities or foreign currency) is adjusted on a frequent basis. If the risky assets fall in value, exposure is reduced, ultimately to zero. If the assets rise in value, exposure is increased so that the fund participates in the gains.
Efficient Market HypothesisThe assertion that information is of no value since all public information on a Company is immediately reflected in its share price. in such a market, an investor can attain no more, no less, than a fair return for the risks undertaken. Forms are weak, semi-strong, and strong.
Emerging Markets The financial markets of developing countries, usually categorized by World Bank definitions. Also refers to the countries/economies as a whole.
Enhanced index fund A fund that closely tracks an index, but attempts to outperform the benchmark using risk-controlled trading or overweight/underweight strategies. (see Chapter 15)
Equities This refers to ownership of assets, usually in the form of ordinary shares, as distinguished from fixed-interest bearing securities, such as bonds or gilt edged securities.
Exchange A regulated marketplace for the trading of stocks, options, futures, commodities, etc.
Excess ReturnThe return derived from a security (during a specified holding period) less the return from holding a riskless security (such as a short-term government obligation) during the same period.
Exchange-traded fund (ETF) A basket of securities designed to track an index that trades like a stock and is listed on an exchange.
Ex-dividend A reference to a stock where the value reflects an adjustment for impending dividends. The ex-dividend date (ex-date) is the date after which the stock trades without rights to that dividend distribution. Investors who own the stock on the ex-date will receive the dividend, and those who are short the underlying stock must pay out the dividend.
Exercise Price The price at which the option holder has the right to buy or sell the underlying commodity, currency, or investment instrument. (Also referred to as "strike price").
Expected return The result of mathematical analysis involving statistical distributions of stock prices and their impact on the value of an investment.
Expense ratio A percentage of assets paid by fund shareholders to cover the expenses of managing the fund.
Expiration date The day on which all open positions in a futures contract are transformed into delivery or receipt responsibilities for the underlying instrument.
Fixed Interest Income which remains constant and does not fluctuate, such as income derived from bonds, annuities, and preference shares. The percentage return from this income varies depending on the market price.
Float The number of shares outstanding of a stock available for purchase by the public on open markets.
Floating rate notes Bonds whose coupon is not fixed, but variable.
Forward Interest Rate The prevailing interest rate for a contract in a specific future, "forward," time period.
Future A standardized agreement, traded on a futures exchange, to buy or sell an instrument at a specified price at a date in the future. The contract specifies the instrument, quality, quantity, delivery date and settlement mechanism.
Gamma The degree to which an option's or portfolio's delta changes as the underlying instrument's value changes.
Geometric average (mean) The mean of n numbers expressed as the n-th root of their product.
Growth fund A mutual fund that invests in stocks whose primary objective is capital (price) appreciation. Growth funds typically experience greater share-price volatility than more conservative funds. (See also Value Fund.)
Hedge The purchase or sale of a futures contract or other derivative as a temporary substitute for a cash market transaction to be made at a later date. The hedge position is designed to protect the investor from temporary price movements in an instrument that the investor already owns or plans to own.
Hedge fund A fund generally available only to institutions and wealthy investors that uses aggressive strategies, such as 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.
Index See Benchmark.
Index arbitrage Investment strategy designed to take advantage of pricing inefficiencies between the price of stocks in an index and the price of index futures contracts.
Index fund Fund with an investment policy of closely tracking the performance of a market benchmark, such as the S&P 500 or Lehman U.S. Aggregate Bond index. Increasingly available for most asset classes.
Index option An option whose underlying price is determined by an index.
Index tracking Correlation between fund's return vs. return of index.
Indexation A 'passive' investment strategy designed to match the returns of a benchmark index. Can be implemented for equity, fixed income, real estate, commodity and other indexes.
Indexed-linked bonds Bonds whose coupon payment is tied to an inflation index. Also referred to as inflation linked bonds.
Indicative Optimal Portfolio Value (IOPV) The value of the securities in an exchange-traded fund, plus estimated cash. An ETF's IOPV by Bloomberg as an estimate of NAV and updated every 15 seconds and should closely track NAV.
Individual Retirement Account (IRA) An account that enables individuals to set aside up to $2,000 of earned income each year toward retirement.
Initial margin Amount of collateral (cash or securities) required by the Federal Reserve board or by a broker, in order to buy on margin.
Institutional investor An entity-such as a foundation, endowment or retirement plan-that invests a portfolio on behalf of a group of individuals-employees, for instance-to achieve specific objectives. Trade sizes tend to be much larger than retail trades, and are often dealt over the counter, directly with the fixed income market maker. Pricing is usually more competitive for these larger institutional investors, versus retail clients.
InterestThe amount a borrower pays to a lender for the use of money.
Interest Rate FuturesA transferable agreement to make or take delivery of a fixed-interest security at a specific time, under terms and conditions established by the market upon which futures trading is conducted.
Intrinsic ValueThe actual money value which an object possesses in itself; its value in relation to unsatisfied wants. As applied to securities, it means value as an investment- the basic worth of a corporation, as calculated by its past record, potential earning power, and underlying equities. As applied to a call (put) option is the amount by which the strike price is less (more) than the market price. It is the value of an option if it is exercised immediately.
Investment objective A stated financial strategy or goal followed by a mutual fund.
Leverage The use of borrowed money to enhance future returns (adds more risk).
Limit order An order that can be filled only at a specified price or better.
Liquidity The degree to which a financial instrument is traded. Highly liquid stocks can experience high trading volume without a dramatic change in price.
Liquidity risk The cost of selling an illiquid asset that lacks a large market for buyers and sellers. Illiquid assets have larger bid/ask spreads, and any buying or selling usually triggers price movements.
Liquid Market A market where buying and selling can be accomplished with ease due to the presence of a large number of interested buyers and sellers willing and able to trade substantial quantities at small price differences.
Listed option An option contract traded on a stock or futures exchange.
Load A sales charge added to the purchase and/or sale price of some mutual funds and annuities. Deferred loads are back-end sales charges imposed when investors redeem shares.
Long Owning an asset in the hope that its price will rise.
Long-term bonds Generally, bonds with maturities of ten years or more. These bonds typically pay investors higher yields to compensate for a greater time commitment. Long-term bond values tend to be more sensitive to interest rate changes, and therefore may have greater price fluctuation, than short-term bonds.
Margin call A demand from a broker for additional cash or collateral to cover adverse price movement.
Market capitalization The value of a publicly traded firm; found by multiplying the number of its outstanding shares by the current market price per share.
Market maker An exchange member whose function is to aid in the making of a market, by making bids and offers for his or her account in the absence of or in addition to public buy or sell orders.
Market on Close Order A buy or sell order to be executed as close as possible to the end of the trading day.
Market Price The last reported price at which the security sold.
Marketable Securities Securities for which there is always a ready market available, such as active, listed securities.
Matrix pricing A security whose price is not explicitly calculated, but rather, whose price is determined by a relationship to other, more liquid securities.
Maturity The date when a debt is due to be paid.
Median Not to be confused with average (or mean), the median is found by arranging all the numbers in a set, and choosing the middle number. If the set has an even amount of numbers, then the median is the average of the two middle numbers.
Modern Portfolio Theory (MPT) The theory of portfolio management/ construction optimization which accepts the risk/reward trade off for total portfolio return as the crucial criterion.
Mutual offset Elimination or reduction of a current long or short position by making an opposite transaction of the same security.
Net asset value (NAV) The value of one share in a mutual fund company computed daily. In general, it is calculated by summing the values of all the fund's investments, subtracting its expenses and liabilities, and dividing by the number of shares outstanding.
Non-systematic risk Stock-specific risk, which is in addition to risk or volatility of the overall market.
OECD country Member of the organization for economic co-operation and development. Member countries tend to be more developed economies.
Option Contracts giving the holder the right but not the obligation to purchase or sell a security on or before a predetermined future date for a fixed price. Options on securities indexes are similar, but settled in cash.
Option Premium Amount per share paid by an option buyer to an option seller for the right to buy (call) or sell (put) the underlying security at a particular price within a specified period.
Out of the Money A call option whose strike price is higher than the market price of the underlying security, or a put option whose strike price is lower than the market price of the underlying security.
Over the counter (OTC) Private trading transactions directly between two parties, not intermediated by an exchange, with details of the transaction not public either.
Overwriting Strategy of selling call or put options over an existing position, betting that they will not be exercised, but having the underlying to deliver in case they are
p/b ratio Price-to-book ratio. The p/b ratio of a company is calculated by dividing the market price of its stock by the company's per-share book value.
p/e ratio Price-to-earning ratio. The price of a stock divided by its reported earnings. It is an indicator of how much investors are willing to pay for an opportunity to share in firm's future earning potential.
Passive management Investment strategy designed to closely track an index.
Pit Area of an exchange where a particular future or option is traded in the open outcry method
Portfolio Composition File (PCF) This data file is published daily and made available to NSCC participants. For each item is contained the security holdings for one basket along with necessary cash information to create one unit.
Portfolio trade Sale or purchase of a basket of stocks in a single trade.
Protective Put The combination of a long put contract and a long position in the underlying stock, to defend against a drop in the underlying stock.
Put An options contract that gives the holder the right to sell the underlying instrument at a specified price for a certain, fixed period of time. (See also Call.)
Potable bonds Embedded put option, gives investor the right to sell the bonds back to the issuer at a pre-determined price.
Quantitative Management An approach to investment management which seeks to use statistical or numerical methods in order to create portfolios, with the optimum risk/return trade-off.
Real Estate Investment Trust (REIT) A corporation or trust for the securitization of real estate property and loans. REITs are traded on an exchange, so are usually more liquid than individual properties.
Rebalancing The process of adjusting portfolio assets back to their original levels, in response to market movements.
Redemption Price The price at which a bond may be redeemed before maturity, at the option of the issuer. Also applies to the price the company must pay to call in certain types of preferred stock.
Regression analysis A complex statistical technique used to find relationships between variables for the purpose of predicting future values.
Retail investor A non-institutional investor. Retail investors encompass individual investors, as well as brokers or intermediaries who trade on behalf of individual investors. Trade sizes tend to be much smaller than institutional trades.
Return The value received (income plus capital) annually from an investment, usually expressed as a percentage.
Risk The volatility of returns, usually expressed as standard deviation.
Risk Premium The extra yield over the risk free rate demanded by investors to compensate them for holding a riskier asset.
Risk Return Spectrum A concept used to illustrate that higher anticipated rewards are always accompanied by incremental increases in risk.
R-squared A statistic which indicates how much of a fund's fluctuations were attributable to movements in the fund's benchmark index. R-Squared ranges between 0 percent and 100 percent, which would indicate that 100% of the movements in a fund were completely explained by movements in the benchmark index.
Sector A group of securities that share certain common characteristics (e.g. operate in the same industry).
Security The paper right to a (generally tradable) asset.
Settlement date Day when the exchange of cash or securities is completed, usually three days after the trade was executed.
Sharpe ratio A measure of risk developed by Nobel Laureate William Sharpe. Calculated by dividing the returns in excess of the 90-day T-bill rate by the standard deviation of those returns for a given time period.
Short An investment position that will profit from a decline in price.
Short sale Sale of a security or other asset borrowed by the seller from a broker, with the understanding that it must later be bought back (ideally at a lower price) and returned to the broker.
Short-term bonds Generally, bonds whose maturity is between one and five years. The price and yield of short-term bonds will fluctuate, however both yields and volatility are lower than with long-term bonds.
Specialist A stock exchange member who makes a market in an exchange-traded security.
Spread The difference between the best bid and best offer for a given instrument at a given point in time. Also called the bid-offer spread or bid-ask spread.
Standard deviation A common measure of portfolio volatility. The distribution of returns around the mean.
Step–up coupons Bonds with fixed coupons, whose coupon level increases to a specified level should a specific event occur. E.g. in event of a credit rating downgrade, the coupon paid on the bond increases by a specified amount for the remaining life of the bond.
Stock Lending (or Securities Lending)The process whereby stocks and gilts owned by one party can be loaned to another. Typically, this process is transacted via a money broker and requires a small fee.
Stock option Put and call options where the underlying is a company's stock.
Stop order An order to buy or sell when the market reaches a specified point.
Style drift When a fund moves away from its stated investment objective over time. For example, a growth fund gradually shifts to value.
Swap An agreement to exchange of streams of periodic payments over time with a counterparty, according to specified terms.
Synthetic asset A package of risks and returns created by combining other instruments to approximate very closely the package of risks and returns available in a traditional security.
Synthetic equity A derivative instrument with the essential risk/reward characteristics of a direct investment in a stock, a specific basket of stocks, or an appropriately weighted basket of stocks equivalent to a stock index.
Systematic risk The risk associated with general market movements, rather than the risk associated with an individual security movement (see also Nonsystematic risk). Systematic risk can usually be hedged with stock-index futures or options.
Systemic risk The risk associated with the general health or structure of the financial system. It occurs as a result of the system's ability to handle large quantities of political market, credit, or settlement risk. A good example of systemic risk was the ‘contagion effect’ of the Asian financial crisis of 1997-1998.
Tactical Asset Allocation To sell asset classes that have strengthened and buy asset classes that have weakened in anticipation of the market returning to equilibrium.
Total Return The aggregate increase in the value of the portfolio resulting from the net appreciation (or depreciation) of the principal of the fund, plus or minus the net income experienced by the fund during the period.
Tracking error The difference between the performance of a portfolio of stocks vs. an index.
Trading limit The maximum price change permitted in a trading session.
Transaction costs Costs incurred when buying or selling an asset, such as broker commissions and the bid/ask spread.
Trend A persistent and pervasive change in direction over a period of time of commodities, prices, earnings, etc.
Turnover (value of security purchases + value of security sales) / value of portfolio, for a specified time period.
Underlying Security The shares of stock (or other security) subject to the exercise of an option.
Underwriting An adoption of a risk at a fixed time in the future for a consideration today.
Universe A list of assets eligible for inclusion in a portfolio.
Unlisted Securities Securities which are not listed on a recognized Stock Exchange.
Value fund Specializes in the purchase of inexpensive stocks - companies with low valuations. A variety of different measures are used to determine 'value' characteristics -- see Chapters 7 and 8
Variance The second moment around the mean; the expected value of the square of the deviations of a random variable from its mean value.
Venture Capital Capital which is subject to more than a normal degree of risk, usually associated with a new business or start up operations.
Volatility The rate at which an asset moves up or down (see also Standard deviation).
Volume The number of shares traded in a given market.
Wash Sale Rule A wash sale is invoked when a security that was sold for a capital loss is bought back within thirty days of the sale. When a wash sale occurs, the fund is disallowed from realizing that loss and must defer it until the security is sold out completely for more than thirty days. The SEC created this law as prevention to amassing capital losses without truly selling out of a security position.
Weighting The specification of the relative importance of each of a group of securities or asset classes that are combined.
Yield Used in reference to bonds, yield is the coupon payment divided by the bond's face value if held to maturity. Bond yields and bond prices are inversely related.
Yield Curve A visual representation of the term structure of interest rates. It shows the relationship between bond yields and maturity lengths.
Yield to Maturity The yield, or return, provided by a bond to its maturity date; determined by a mathematical process, involving discounting future cash flows to calculate an internal rate of return.

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