Financial markets are a vital component of any economy. Basically, they make it easy for buyers and sellers to trade financial assets. And there are several different types of markets in which to do this. They range from stock markets, to forex and money markets, and even cryptocurrency.
With so many different ways to trade assets, fund management can become a maze of complicated terminology. In this blog, we’ll walk you through all the jargon you need to know, so that you can make sense of market terms in fund management.
Basic Market Terms in Fund Management
As you delve deeper into terminology, you’ll notice that it becomes slightly more niche and complicated. But before we get to that, let’s cover the basics.
Net Asset Value
Net Asset Value (NAV) refers to a fund’s overall value. It’s calculated by subtracting assets from liabilities. However, in the case of an investment company that makes regular transactions and trades, these values will change on a daily basis. As such, their NAVs fluctuate daily, too. For this reason, most funds calculate their NAV at least once a day, usually after the major exchanges close.
Remember that this extends to a fund’s share price on a given day. To calculate the price, divide the fund’s NAV by the number of shares outstanding at that particular time.
NAV is calculated daily for open- and closed-end funds. The former can issue an unlimited number of shares and don’t trade on exchanges, like a 401(k). The latter are listed on the stock exchange and trade at a price, like stocks.
Sometimes, investors will try to determine a fund’s performance based on the NAV, by comparing an amount at the start of the year against one towards the end of the year. Unfortunately, this isn’t actually an accurate measure of performance. It doesn’t account for capital gains, dividends, or interest earned. A better way is to look at a fund’s annual total return. This means the actual rate of return of an investment over a specific period.
Expense ratio
This ratio illustrates how much you pay a fund per year. It’s expressed as a percent of your investments, by dividing the fund’s operating expenses by net assets. This lets you work out how much it will actually cost you to invest in a specific fund. The ratio also lets you determine accurate returns.
The expense ratio is one of the fundamental market terms in fund management, although the chances of actually having to calculate it are rare. You see, this ratio should be stated in your fund’s prospectus.
Keep in mind, however, that a fund’s trading activity—the buying and selling of portfolio securities—is not included in the expense ratio calculation.
Assets Under Management
Assets under management (AUM) are the market value of investments managed on your behalf. How it’s calculated may vary between companies. After all, it depends on how much money is going into and out of a fund. Factors like how assets perform or dividends are reinvested, along with capital appreciation, and acquiring new customers can all increase a fund’s AUM. On the other hand, the value will decrease in the event of fund closures, market value losses, and fewer investors.
Generally, AUM is calculated by aggregating the total market value of all assets overseen on behalf of a fund’s clients. So it can fluctuate constantly, depending on activity across investments, and currency changes.
In most cases, higher AUM is considered a good sign of efficient fund management. Unfortunately, this does not always mean that a fund with a high AUM will guarantee success.
To ensure you’re making a good investment choice, you also need to consider a fund’s performance.
Performance Metrics
This next batch of market terms in fund management are all about how a fund performs, and the specific metrics to keep in mind in this regard.
Alpha and beta
These measurements are used to determine the historical performance of a fund, portfolio, or stock. Alpha indicates your return on investment (ROI) against a benchmark like a market index. Beta shows how risky your investment is, based on market volatility. Alpha and beta measure investment performance, by illustrating if your investment has over- or underperformed based on its risk.
If your alpha is positive, it generally means that your investment has performed well and provided higher returns than expected. If alpha is negative, it’s underperformed, with lower returns than expected. Basically, a high alpha is always good.
And what about beta? A beta of 1 generally means that the price of your investment is in line with market averages. If it’s greater or less than 1, this indicates that a fund has higher or lower volatility, respectively.
Sharpe ratio
A Sharpe ratio is one of the market terms in fund management that can help you evaluate investment risk over time. It’s a widely used formula in the investment world.
It’s calculated with a mathematical formula, but is essentially two parts. The numerator reflects the time difference between your realized or expected returns from an established benchmark. The denominator is the standard deviation (more on this in the next section!) of returns over the same period. In other words, it’s also a measure of volatility.
In a nutshell, the ratio divides excess returns by volatility to determine performance. Usually, the higher the ratio, the more attractive the risk-adjusted return. It’s a great way of helping you work out whether any excess returns are because of luck, or down to smart investment decisions.
Be aware that portfolio managers can manipulate Sharpe ratios by extending the measured intervals. That way, they make it seem as though their funds are performing better than they actually are.
Standard deviation
This is another one of the many market terms in fund management to measure risk. In fact, it’s probably the most common way to do that. Standard deviation calculates how much your investment prices differ from the market average. Huge differences between what you pay and the current market price mean a high standard deviation, or that the investment is risky. Conversely, a low standard deviation means the investment is relatively safe.
Calculating this metric requires a difficult mathematical formula, but basically, it gives you an idea of the variance between prices.
Market Strategies and Concepts
Now that you have an overview of market terms in fund management, let’s move on to the language used to refer to investment strategies.
Long/short strategies
This refers to an investment strategy that takes long positions in stocks expected to appreciate, but short positions in stocks expected to decline. In other words, it’s a way of minimizing market exposure. This is done by making the most of potential profits from both under and overvalued investments.
This strategy is popular in hedge funds, which we’ll cover below.
Hedge funds vs. mutual funds
These are two common market terms in fund management that you’ve probably heard often. Both types of funds are managed portfolios consisting of pooled funds. The goal is to achieve returns through diversification with investment capital from different sources.
The difference between the two is that hedge funds usually target high-net-worth investors, and they’re private investments. They’ll also often have higher-risk investment strategies than mutual funds.
Mutual funds, on the other hand, offer a variety of investment options for public investors.
Both are traded daily on market exchanges, and are regulated by the Securities and Exchange Commission (SEC), and require a documented prospectus for transparency.
Market timing
Market timing refers to moving money in or out of a financial market, or switching funds between asset classes. All of this is done by making predictions about what the market will do. It’s one of the basic strategies that most traders use. Still, it’s a tough skill to master, and not everyone can do it accurately.
Like any investment strategy, it comes with pros and cons. The advantages of market timing include potentially larger profits and reduced losses, while avoiding intense market volatility.
But there are a few downsides, too. For instance, you need to watch the markets constantly, and you’ll have more frequent transaction costs. Also, remember that your investments may be subject to short-term capital gains tax.
As always, when considering any investment strategy, it’s best to consult with a finance professional.
Advanced Market Terms
Now let’s dive into some advanced terms that you may come across in the industry.
Derivatives
These are financial contracts between two or more parties. They derive value from an underlying asset (or group of assets) or a benchmark. These contracts can be used to trade any assets, either on an exchange or over the counter.
There are several different types. These include:
- Futures: Agreements for the purchase and delivery of an asset at an agreed-upon price at a future date, on an exchange.
- Forwards: Similar to futures, but these are traded over the counter.
- Swaps: Here, one kind of cash flow is exchanged with another.
- Options: Like futures, these are an agreement to buy or sell an asset at a predetermined future date for a specific price. Unlike futures, this isn’t an obligation – it’s just an opportunity.
Note that derivatives don’t have intrinsic value – they depend on the underlying asset. This means that they’re vulnerable to market risk and sentiment.
Leverage
This refers to using borrowed capital as a source of funding, to increase the ROI. It basically means you use debt to make an investment.
It’s calculated through a group of financial ratios, like your debt ratio (debts compared to assets), debt-to-equity ratio (how your assets are financed), or debt-to-EBITDA ratio. This reflects how much income you generate in a given period using your Earnings Before Income Tax, Depreciation, and Amortization (EBITDA).
Liquidity risk
Liquidity is how easily you can buy or sell an asset, and convert it to cash. In the context of market terms in fund management, liquidity risk is asset illiquidity. This means an inability to easily exit a position.
Practical Applications of Terminology
Now that you know about market terms in fund management, you can use this terminology to read fund prospectuses and reports. A prospectus is a formal document that gives you details about an investment. That way, you can make more informed decisions, based on data.
Knowing what terms are relevant to your investments can also help you evaluate fund performance. Knowing about the alpha, beta, standard deviation, and Sharpe ratio helps you assess a fund’s performance, to gauge if it’s performing well.
A crucial component of this terminology is that it’s essential for compliance. By knowing what your fund manager is speaking about, you’ll know whether your investments meet legal standards.
For help navigating fund management, and how this affects your finances, schedule a Discovery Call with one of our CPAs.
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.
