A guide to investment:

principles, drivers & terminology

 Contents
03 1: An explanation of financial terminology
10 2: Valuing companies and their equity
12 3: Economics: the building blocks of investment
13 4: Economics: inflation
14 5: Economics: welfare
15 6: Government policies
16 7: Exchange rates
17 8: Fixed income: a lower risk option
19 9: Investment management approaches

A GUIDE TO INVESTMENT: PRINCIPLES, DRIVERS & TERMINOLOGY | 2

1: An explanation
of financial terminology

AN EXPLANATION OF FINANCIAL TERMINOLOGY | 3

Active management: Active management is when referred to as a “bear”. Bear markets can last for a few
investment managers take action (i.e. pick stocks) weeks or years. The reason it’s called a Bear market
in an effort to outperform the market. To do this, they is that when a bear catches its prey it pushes it down
use proactive analysis, research, market forecasts, with its paw.
and expert judgement. As a result, active management
Beating the market: Making an investment return
fees are generally higher than those for passively managed
that is greater than the return achieved by the stock
funds, or index tracker funds, which only track the market.
market as a whole.
Alpha: Alpha is a measurement of the difference between Beta: A measurement of an investment’s sensitivity
a fund’s performance and the market’s performance. It is
to market fluctuations. The higher a fund’s Beta,
often used as a measurement of fund managers’ skills.
the higher its sensitivity to market movements.
Analyst (financial analyst): A professional whose Blue chip: Blue chip companies have a long history
responsibilities include: collecting, analysing, and
of good earnings, good balance sheets, and even
interpreting financial data, and preparing reports,
regularly increasing dividends. Owning equity in these
models, and buy or sell recommendations.
companies might not be exciting, but is likely to provide
Annualised rate of return: The annualised rate reasonable returns over time.
of return is the net return over a given period
Bond: Bonds are used by companies and governments
(e.g. 3 years) expressed as an annual percentage.
who want to raise money. When you buy a bond, you are
Asset: Assets include stocks, bonds, commodities, buying the promise that your money will be returned with
real estate, cash, property, works of art and other interest.
investments. An asset is something which allows
Book value: The liabilities a company has minus its assets
you to earn money simply through owning it.
and common stock equity. Book value is usually used
Asset allocation: It is possible to divide up the holdings as part of a valuation measure, rather than being directly
in your portfolio by asset classes (e.g. equities, bonds, related to a company’s market value.
commodities, etc.). Each asset class performs differently,
Bull market: A market that is going up. If you think that
meaning that exposure to a higher number of them lets
the market is going to go up, you are considered a “bull.”
you mitigate risk.
You can also be “bullish” on a specific company, meaning
Assets of a fund: The investments that are held you think its stock price will rise. The reason it’s called Bull
within a fund. market is because a Bull throws its prey upwards with its
horns.
Balance of trade (country): The difference
in value between a country’s imports and exports. Capital gain (or loss): The difference between the price
you paid for an investment, and the price you sold it for.
Balance sheet: A statement showing company
If you buy 200 shares of a stock at $10 a share (spending
assets and liabilities, and stating the outstanding
$2,000) and sell your shares later for $25 a share ($5,000),
shareholder equity.
your capital gain is $3,000. A loss occurs when you sell for
Bear market: A market that is falling. Someone less than you paid. So, if you sell this stock for $5 instead
who believes the market is headed for a drop is often ($1,000), you have made a capital loss of $1,000).

AN EXPLANATION OF FINANCIAL TERMINOLOGY | 4

Capital growth: An investment’s increase in value over Correlation: A measurement of any two assets’ linear
time (excluding income). Funds targeting capital growth return relationship, and the extent to which their
aim to select stocks that will appreciate in value, movements are related. Correlation can be any value
rather than deliver ongoing income to investors. . between +1 and -1. Portfolios can be diversified by
combining investments that have low correlation to
Cash: All money, paper or digital. In relation to funds,
each other. Correlation of +1 means assets have always
cash usually refers to the percentage of a fund that is on
historically moved in the same direction when markets
deposit rather than invested into another asset class.
change, whereas correlation of -1 means assets have
Often, this is because fund managers expect valuations
always historically moved in the opposite direction.
to fall, presenting an opportunity to buy more cheaply.
Coupon (Bond): The yearly interest payment
Cash flow: The net amount of cash and cash-equivalents
to bondholders, received from the bond’s issue date
being transferred into and out of a business. At the
until maturity. Coupons are normally described in terms
most basic level, a company’s ability to create value for
of the coupon rate, which is the sum of coupons paid
shareholders is dependent upon its ability to generate
per year divided by the bond’s face value.
positive cash flows (or, more precisely, optimise long-term
free cash flow). Depreciation: An accounting method that allocates
the cost of a material asset across its life expectancy.
Collective investment scheme (CIS): Sometimes
This measure makes it easy to see how much of an asset’s
referred to as a “pooled investment”, a CIS is a fund which
value remains at any time. Depreciating assets helps
multiple people contribute to. A fund manager invests the
companies earn revenue from an asset while expensing
collective wealth in holdings belonging to one or more asset
a portion of its cost each year the asset is in use,
class (stocks, bonds, property, etc.).
and can make a big difference to profits.
Commodity: Commodities are an asset class made up
Derivative: Financial contracts whose value is related
of useful, tangible, goods, such as industrial and precious
to the value of a financial index or underlying asset.
metals, oil and natural gas, and agricultural products.
Often used for risk management purposes (see ‘Hedge’)
or to increase returns.

AN EXPLANATION OF FINANCIAL TERMINOLOGY | 5

Diversification: The strategy of ensuring you have more Fixed income: An asset class comprising bonds and
than one type of asset in a portfolio, helping to reduce risk. gilts, where the amount of income paid out is fixed.
This term does not just apply to asset classes, but can
Free cash flow (FCF): A measure of the cash a company
also be used in regards to different sectors, industries,
produces through its operations, minus expenditure on
or geographic locations.
assets. Free cash flow can be used to determine whether
Dividend: A payment made when a company decides a company will have enough cash (after funding operations
to divide up some income amongst shareholders. and capital expenditures) to pay dividends and commit
Dividends can be paid as a one-off or they can be paid to share buybacks.
regularly (monthly, quarterly, semi-annually, or annually).
FTSE: The Financial Times Stock Exchange 100 Index
Dollar cost averaging: The effect produced by investing is an equity index comprising of the 100 largest companies
in a fund on a regular or frequent basis is described as on the London Stock Exchange, measured by market
dollar cost averaging. If asset prices fall, the regular capitalization. Also called the FTSE 100 Index, FTSE 100,
payment buys more units, but if they rise, the regular FTSE, or, informally, the “Footsie”.
payment buys fewer units. Unlike investing in a single
Fund of funds: A fund that only invests in other funds.
lump sum, this approach mitigates the effect of volatile
Funds of funds are either ‘fettered’ (meaning all of the
markets on your investments.
underlying funds held in the fund of funds’ portfolio
Dow Jones Industrial Average: A price-weighted list will be managed by the same company) or ‘unfettered’
of 30 blue-chip stocks. Despite its small size, many people (meaning the underlying funds will be from different fund
think of the Dow when they hear that “the stock market” management groups).
gained or lost, and it is often used as a gauge of the whole
Fund manager or fund management: The firm
stock market’s health.
responsible for deciding how a fund should be invested.
Earnings per share (EPS): The portion of a company’s Working within established regulations, they can also
profit allocated to each outstanding share of common be described as the ‘fund provider’.
stock. EPS indicates how profitable a company is for the
Futures: standardised financial contracts between
owner of a single share
two counterparties, in which the buyer purchases an
Enterprise value (EV): A more comprehensive underlying asset (e.g., financial instruments or physical
measure of a company’s total value than equity market commodities) at a pre-determined future date and price.
capitalization. EV includes the company’s market
GARP (Growth at a reasonable price): When a
capitalisation, short-term and long-term debt,
company’s shares are valued at a premium which is within
and any cash on the company’s balance sheet.
the historic range (or not very different from comparable
Equities: Equities are shares in a company. If you own growth companies), but which is justified by consistent
a share or an equity in a company, it means that you earnings growth, .
are a part owner of it together with hundreds, thousands,
Gain: The profits made when assets are sold for more
or hundreds of thousands of other people.
than they were bought for.
Equity exposure: Literally, the amount of the fund
GDP: Gross Domestic Product (GDP) is the total value
that is exposed to (i.e.: contains) equities. If a fund’s
in monetary terms of all finished goods and services made
equity exposure is 30%, it means 30% of its value
within a country during a specific period. GDP can be
is invested in equities.
used to estimate an economy’s size and growth rate,
ETF: Exchange-traded funds are investment funds and can be calculated in three ways (using expenditures,
that mirror an index and trade like a stock. Investors buy production, or incomes).
and sell ETFs on the same exchanges as shares of stock,
Government bond: A bond issued by the Government.
and gain exposure to an entire market as a result.
Growth fund: These funds target future gains, typically
EURO STOXX: A series of equity indexes that only
investing in stocks whose earnings outperform the market.
include shares of Eurozone companies. Designed by
A growth fund manager will try to achieve success by
STOXX, an index provider owned by Deutsche
focusing on fast-growing sectors and looking for high-
Börse Group.
profile companies within them that deliver consistent
Exchange: A place to buy and sell investments, earnings growth. Appreciation of individual share prices in
including stocks, bonds, commodities, and other assets. the funds’ portfolios is what drives these funds’ growth.
Today, most of these orders are executed electronically.

AN EXPLANATION OF FINANCIAL TERMINOLOGY | 6

Growth investing: This investment strategy focusses Initial Public Offering (IPO): When a private company
on capital appreciation. Growth investors look for offers shares to the public in a new stock issuance. This
high-growth companies and are often willing to pay allows the company to raise capital from public investors.
higher prices for them in terms of metrics such as
Interest rate risk: A measurement of a bond or fund’s
price-to-earnings or price-to-book ratios.
sensitivity to interest rate changes for the remainder of its
Growth rate (company): The amount by which certain lifecycle In the event of an interest rate increase, a decrease
values (such as turnover or profits) increase over a specified in price would correspond with higher interest rate risk.
period. The terminal growth rate is made on the assumption
Investment manager / fund manager: The person
that growth (or decline) will hold constant in perpetuity.
or company responsible for investing and managing the
Perpetuity growth rates tend to fall between the historical
money held within a fund.
inflation rate of 2 - 3% and the historical GDP growth rate
of 4 - 5%. Investment objective: The objective that a fund was
created to achieve. For example, the generation of income,
Hedge: The opening of a position intended to offset
provision of capital growth, or the protection of capital.
potential losses from another investment.
Liquid or liquidity: The speed and ease with which
Historic yield: A measurement of dividends paid out
an investment can be bought and sold.
over the previous year divided by the current price and
expressed as a percentage. Long: To retain an investment in your portfolio on
the assumption that its value will increase over time.
Real implied growth rate: This measurement describes
(See ‘Short’).
the market expectations for long-term earnings growth that
is implied by a share price. Comparing a company’s RIGR Market capitalisation: A company’s “market cap”
to that of its industry or the wider market can help investors is a measure of its size and / or value. A company’s
identify over and undervalued firms. market cap can be found by multiplying its share price
by the number of shares existing.
Index: A tool that tracks the progress of a group of stocks,
bonds, or other assets, that share certain characteristics. Small cap: Market cap <$1billion
Mid cap: Market cap $1 billion to $10 billion
Index fund / index tracker: A mutual fund which mimics
Large cap: >$10 billion
an index’s performance, letting investors gain exposure to
a large basket of stocks in a single investment. These tend
to be passive investments, and have relatively low fees.

Inflation risk: The risk that the purchasing power of

savings will fail to keep pace with the rate of inflation.

AN EXPLANATION OF FINANCIAL TERMINOLOGY | 7

Mixed asset funds: Funds that have the freedom to Passively managed funds:
invest in a wide variety of asset classes, such as cash, (See: index fund / index tracker).
bonds and shares. In theory, the fund’s performance
Performance: A measurement of elements such as
would not be reliant on any one type of asset.
capital growth & income paid against the wider market,
Money market account: An interest-bearing account sector or other benchmark. (See ‘Total Return’).
that usually pays a higher interest rate than traditional
P/E ratio: How much you pay for company earnings.
savings accounts.
If a company reports earnings of $5 per share, and each
Multi-manager fund: A fund which invests in other share is selling for $75, you can work out the P/E ratio as
managers’ funds as opposed to underlying assets (stocks, follows: divide 75 by 5. The answer is 15. In other words,
bonds, etc.). (See ‘Fund of Funds’). you have paid $15 (when you bought the share) for every
$1 of earnings (in the time specified – companies usually
Mutual fund: This type of fund purchases assets with
report earnings once per quarter). The higher a P/E ratio is,
money pooled from individual investors. The fund can hold
the greater expectations are for higher earnings.
individual stocks or bonds and is actively managed by
a professional portfolio manager. As a result, these funds Portfolio: A collection of investments.
usually have higher fees than other investments.
Pound cost averaging: (See dollar cost averaging).
NASDAQ: The National Association of Securities Dealers
Personal investment strategy: There are many
Automated Quotations. A U.S. exchange for buying and
different approaches to investing. Individual investors
selling securities that is based in New York City. The term
should learn how investing works and decide on
also refers to an index of the stocks bought and sold on
a personal strategy that’s right for them.
the Nasdaq exchange.
Provision: Items in a company’s accounting records
NAV (net asset value) of a Fund: The entire
that represent funds put aside to pay for anticipated
summarised value of a fund’s liabilities and assets.
losses or costs.
This can be expressed as a total fund size in monetary
terms or as a price per unit. Public company: (Alternatively: a publicly traded
company, publicly held company, publicly listed company,
NYSE (New York Stock Exchange): One of the most
or public limited company). A company which is owned
famous stock exchanges in the world. The NYSE trades
via shares of stock traded on a stock exchange or in
stocks in US and some international companies.
over-the-counter markets.
Open-ended fund: A fund where the number of shares
Real return: The rate of return on an investment once
or units in existence can increase or decrease as investors
inflation has been accounted for (e.g.: if an investment
buy-in or sell-out of the fund In theory, the number of units
returns 10% over a year but inflation is 3%, then the real
that can be created is unlimited, hence the use of the term
return is 7%).
“open ended”.

AN EXPLANATION OF FINANCIAL TERMINOLOGY | 8

Recession: Usually defined as a decline in GDP (gross Switching: When an investor sells their holdings in one
domestic product) for two consecutive quarters. fund and buys shares in another fund managed by the
same firm, they will usually have to pay a switching fee.
Redemption: When an investor sells shares back to
a fund manager. In most funds, investors can redeem part S&P 500: The Standard & Poor’s 500 is a stock market
or all of their investment at the fund’s next valuation point comprised of 500 US companies. Like the Dow Jones,
and receive cash shortly thereafter. it is also a stock market index.

Return: A fund’s return consists of two main elements Stock: (See Share. See Equity)
- the income earned by an investment minus costs,
Total return: A combination of the total income received
and appreciation in an investment’s capital value.
from an investment (minus costs) and its capital return.
Combined, these are a fund’s total return.
Tracker Funds: A tracker fund mirrors a specified index,
Risk profile: All investors have a risk profile, which is
holding all of that index’s stocks and copying its pattern
used to describe the extent to which they can face the
of buying and selling shares. The goal is to mimic an
loss of capital, or failure to reach investment goals.
index’s performance, thereby gaining access to the
Risk rating: A measurement of a fund’s risk rating. It lets performance of an entire market.
investors gauge a fund’s potential to increase or decrease
Unit: Just as an equity is a share of a company, a unit
in value. Usually, higher risk funds exhibit higher volatility.
is a share of an investment fund. It indicates a proportion
Sectors: Funds can be grouped into “sectors” defined of ownership of the fund in question, and entitles its bearer
by investment objectives, or classes of investment. to a proportionate share of the fund’s investment returns.

Share: A unit of ownership in a company or a Fund. Valuation: A calculation of the overall value of a fund
and the price of a single unit in that fund, including its
Sharpe ratio: The amount of excess return an investment
assets and liabilities.
offers for each additional unit of risk (expressed as
a standard deviation) compared to a risk-free asset. Value investing: An investment strategy that involves
The Sharpe ratio shows whether returns are due to picking undervalued stocks. Value investors hope to benefit
intelligent investment decisions or an abundance of risk. from buying stocks that the market is underestimating.
The higher the Sharpe Ratio, the better the risk-adjusted
Volatility: The measurement of an asset price’s
return, calculated as:
movement up and down over time. More volatile stocks
S = (return of the portfolio – return of the risk-free asset) are, by definition, riskier - however, they sometimes provide
/ standard deviation of the portfolio better returns in the long run.

Short: Selling an investment which you do not currently Yield: If you are a dividend investor, your yield is the ratio
own (often achieved through the use of derivatives). between the price you paid for the stock, and the dividend
This is done in the hope that it can be bought later at it pays to you. For example, if a stock is trading at $100 per
a lower price, therefore allowing the seller to make a profit. share, and pays out a dividend of $5 per year, you can find
It is, effectively, betting against a stock. the yield by dividing the $5 by $100, and turning it into
a percentage. In this case, the yield would be 5%.
Standard deviation: A measure of a portfolio’s total
volatility. It indicates the degree to which a portfolio’s
returns have varied around the average during a set period
of time. The lower this measurement, the lower the risk.

Stock market, or stock exchange: An electronic

system in which trades take place between buyers,
sellers, brokers, and dealers. Securities, bonds and
shares are the assets traded.

Stop loss: An advance order to sell a stock once

it falls below a certain price threshold. Stop loss
systems are used to limit the loss one incurs when
an investment performs poorly.

Style/Investment style: The theory and strategy that

dictates how an investment portfolio or fund is managed.
One example is value investing, which looks to discover
and invest in undervalued companies.

AN EXPLANATION OF FINANCIAL TERMINOLOGY | 9

2: Valuing companies
and their equity

VALUING COMPANIES AND THEIR EQUITY | 10

Investors use company valuations to help Growth investors look for companies offering strong
them make sensible investment decisions, earnings growth.

and have traditionally focused on profit Key characteristics of growth stocks are:
(or “the bottom line”) when producing them. – they are high-priced in the short term because they
However, other financial indicators have are expected to deliver higher growth in the long term
started to play an important part in company
– they have attractive earnings growth records
valuations, as focusing on profit has not
– they are usually more volatile than the wider market
always provided a reliable guide to investment.
Some of the most important company valuation concepts
to be added to an ever expanding toolbox are cash flow, Value investors look for stocks that are undervalued,
net asset value, and enterprise value. A company’s cash flow and hope to reap the rewards of future profits.
refers to the cash it generates, and is usually approximated
Key characteristics of this strategy are:
by the sum of profits and non-cash items in a company’s
profit & loss account (such as depreciation and provisioning). – a belief that markets overreact (over-shoot) to bad news
A company’s net asset value refers to the value of its assets, – the search for stocks which are priced lower than
excluding liabilities. And a company’s enterprise value (EV) both the broader market and similar companies
is the sum of its equities’ market value and its debt’s market in the same industry
value. EV is commonly used in mergers and acquisitions
but is also popular with equity investors. – a potential value trap: companies may be cheap for
a reason, and value investors can misunderstand those
EV is the basis for many valuation measures, which show, reasons. In these cases, the apparently cheap stock
for example, the ratio of EV to sales. Investors also often is in fact correctly priced by the market
calculate the free cash flow of a company (residual cash flow
after interest costs and taxes are taken into account) and
examine the ratio between it and EV. This is known as the Growth at a Reasonable Price (GARP) is an investment
free cash flow yield (FCF yield), and is often used in mergers strategy that combines key facets of both growth and
and acquisitions. If the FCF yield is higher than the cost of value investing. Investment guru Warren Buffett is
debt, it could make sense to acquire a company, as its free a well-known fan of this type of investing.
cash generation could cover the cost. Discounted Cash
Market capitalisation (market cap) is defined as the total
Flow (DCF) methodology is another tool used to determine
value of all outstanding shares of a publicly traded company.
a company’s valuation. This method is often used in capital
It is a rough measurement of a company’s value.
investment decisions and can help to decide if a particular
Definitions of small, mid, large and mega cap companies
project will generate enough revenue to cover expenditures.
are straightforward – but the exact thresholds between
Dominion Asset Management also often applies the implied these levels varies from market to market.
growth rate (G) as a valuation measure. It represents
a company’s growth rate in perpetuity. (The starting point Drivers of equity markets
is the so-called Gordon’s Growth Model G = k – FCF Yield; The macroeconomic environment is a major driver of
where k is the required rate of return for investor) equities. Other, more equity-specific, drivers include
what are known as “company fundamentals”. These are
The stop loss system is designed to avoid major losses,
a business’s economics, such as the balance sheet,
and is often based on the so-called “high watermark”
income statement, cash flow, and overall management
(the highest price of the stock since its addition to the
Taken together, these measures are thought to be indicative
portfolio). The stop loss signal is triggered when
of a company’s health and growth prospects.
a company’s share price falls below the stop loss level.
Financial analysts use company valuations to determine
Quoted Equities the amount they will pay for a stock.
Of all asset classes, equities have shown the greatest
Market expectations are, essentially, investors’ opinions
potential for returns historically. However, they are also
about a company’s prospects, based on the future returns
amongst the riskiest, since their values can fluctuate
that are implied by its stock price. It is important to note that
significantly.
equity markets tend to be similar to other markets in this
regard: they are forward looking and price in expectations.

VALUING COMPANIES AND THEIR EQUITY | 11

3: Economics - the building
blocks of investment
A country’s economy as a whole is referred to as a macro economy.
Macroeconomics is the study of economic data and methods at this
“macro” level, examining areas such as gross domestic product (GDP),
unemployment, and inflation, to help governments determine the
aggregate effect of certain policies on an economy.

Governments will usually strive for: The formula for determining GDP is the sum
of consumer spending (C) plus investments
– A low and stable rate of inflation (typically around 2%)
by firms (I) plus spending by governments
– Equitable distribution of income to create a fair society, (G) plus the difference between exports (X)
without major divisions between rich and poor and Imports (M): GDP= C+I+G+(X-M).

– Unemployment remaining around the natural level In contrast, microeconomics works on

(unemployment and inflation are often linked) a “micro” scale, looking at the behaviour
of individual economic units such as
The total economic output of a country is called companies, industries, or households
Gross Domestic Product (GDP) and reported within an economy.
(usually on a quarterly basis) by national statistics
offices. GDP indicates whether the economy
is growing or contracting.

ECONOMICS - THE BUILDING BLOCKS OF INVESTMENT | 12

4: Economics - inflation
When consumer demand increases, it can cause short term scarcity of products. This limitation
of supply then causes prices to rise. For example, if avocados become the next new superfood,
demand will rocket and supply run low. The price of avocados will then increase, as people
would be willing to pay more for them.

Inflation can also be caused by an increase in production Sometimes, bouts of deflation can be a positive thing,
costs. For example, if sterling depreciates, it will cause as it can increase the purchasing power of money.
avocados, which are bought in Peruvian Sol, to be But long periods of deflation are considered negative
relatively more expensive as an import. In this case, for an economy, as consumers and businesses hoard
British supermarket chains are likely to pass off at least cash and reduce demand, expecting to benefit from
some of this increased cost on to consumers in the form continued falling prices.
of higher prices.
Stagflation is a term that describes increasing
The term inflation refers to an environment of generally inflation alongside a fall in GDP – it arises from
rising prices within an economy. Rising prices impact a combination of the words “stagnation” and “inflation”.
the cost of living, the cost of doing business, borrowing
A Goldilocks economy is when growth isn’t too hot
money, and mortgages. If it is not balanced out by rising
(leading to inflation) nor too cold (leading to a recession).
wages, etc., then increasing inflation causes consumers’
A Goldilocks economy is a healthy economy with
purchasing power to decrease. The measure of inflation
a favourable GDP growth rate of 2-3%, and moderately
over time is referred to as the inflation rate.
rising prices, as measured by the inflation rate.
Deflation is the opposite of inflation: a general decline While deflationary cycles have proved hard to reverse,
in prices. It emerges when the supply of goods and central bankers are generally confident in their ability
services in an economy increases in tandem with demand to control rising inflation.
for cash on the part of both corporates and consumers.

ECONOMICS - INFLATION | 13
5: Economics - welfare
Unemployment occurs when a person who wants work is unable to find it. It is often
used as a measure of an economy’s health. The unemployment rate (the total number
of unemployed persons divided by the total number of people in the labour force)
is the most frequently used measure of unemployment.

Individuals might be unemployed for a variety of reasons, The Phillips Curve is an economic concept
such as the seasonal nature of some jobs (ski instructors, that shows how unemployment and inflation
fruit pickers or those involved in the tourist trade) are related in an economy. It suggests that
or brief periods of joblessness due to a change in career. decreasing unemployment causes an increase
And, of course, companies occasionally fail, and are in inflation, and vice versa, and is a popular tool
forced to make their staff unemployed. Structural for macroeconomic analysis.
unemployment is more serious, and occurs when
unprofitable sectors stop employing workers.

ECONOMICS - WELFARE | 14
6: Government policies
Monetary and fiscal policies are the primary ways On the other hand, reducing interest rates makes
it cheaper to borrow money. This incentivises spending
in which governments seek to achieve their goals
and investment, increasing the money circulating in the
There are three broad approaches here: economy. Generally, this causes inflation to rise.

1 Conventional monetary policy: how central banks

Quantitative Easing (QE), which is the creation of new
electronic money by a central bank, is the major approach
control the supply of money in an economy,
in unconventional monetary policy. This new money is used
usually by targeting an inflation rate or interest rate.
to buy financial assets (such as government bonds), thereby
2 Unconventional monetary policy: unorthodox measures stimulating the economy. When large amounts of government
used when conventional policies are insufficient. bonds are purchased, it increases the money supply and
can reduce the cost of borrowing. In theory, this should
3 Fiscal policy: government use of taxation and spending.
encourage private sector spending, creating higher asset
prices in turn and helping to return inflation to its target.
In conventional monetary policy, central banks Fiscal policy is the adjustment of government spending
control the supply of money through the use of interest and tax rates to affect the economy. Depending on the
rates, which are set to achieve the desired unemployment/ desired outcome, fiscal policy is implemented through
inflation rate. When an interest rate is changed, it affects economic stimulus or austerity measures. To stimulate an
the cost of borrowing/saving. Increased rates incentivise economy, the government will lower tax rates and commit
investors and consumers to pull back from spending, to public spending. Whereas, if a government wants to lower
as the cost of borrowing money has increased. As a result, budget deficits, it will engage in austerity measures, such as
less money circulates in the economy. This causes a fall increasing tax rates and reducing government spending.
in the inflation rate.

GOVERNMENT POLICIES | 15
7: Exchange rates
An exchange rate can be defined as the rate at which one country’s currency
can be exchanged for another’s. Since currencies have value relative to one another,
a depreciation in one country’s currency causes others to be more expensive.

When exchange rates fluctuate, it can have a major impact 3 A deficit in the country’s current account signals
on an investment portfolio’s performance. For this reason, that it is failing to generate enough foreign trade
it is vital that asset managers remain aware of how much to compensate for spending. Put another way,
exposure they have to each currency. Investment managers the country’s demand for foreign currency outpaces
can vary currency exposures (for example through the use its supply, which lowers its exchange rate.
of hedging at various exchange rate levels), thereby letting
4 A country’s currency exchange rate can also be
them adjust overall exposure as needed.
affected by its debt rating. Widespread concerns
over the possibility of a debt default can lead
A number of factors can affect exchange rates.
investors to sell bonds denominated in the relevant
The most important include: currency, resulting in depreciation.
1 When a country with lower inflation rate sees its 5 A number of factors, such as political events or
currency value rise, causing its purchasing power changes in commodity prices, can lead to speculation
to increase against that of other currencies. The result which may cause currencies to fluctuate in value.
is that countries with higher inflation usually see their Foreign exchange rates are highly influenced by
currency depreciate. sentiment in financial markets.
2 Higher interest rates attract an influx in foreign capital, Investment managers often seek to protect against
causing the exchange rate to increase. However, due (sudden) exchange rate changes by currency hedging.
to the correlation between interest rates, inflation and Hedging is an effective way of limiting the risk posed
exchange rates, the effect of this move can be reduced. by foreign exchange, but it can also be expensive.

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8: Fixed income:
the lower risk option?

FIXED INCOME - THE LOWER RISK OPTION? | 17

Fixed income securities are investment Cash
assets which provide returns in fixed periodic Of all assets, cash is the safest but comes
with the lowest returns.
payments, as well as the eventual return
of the original investment. These are usually There are three reasons to hold cash
low risk/low reward strategies, and therefore in a portfolio, which are:
an important component in low-risk 1 Liquidity and opportunity: When asset class valuations
investment propositions. drop to attractive levels, investors that have quick
access to cash can take advantage of them.
Governments, agencies, corporates, banking and
other financial institutions, can all be fixed 2 Reduced portfolio volatility: Holding cash in a fund
income issuers. limits exposure to more volatile markets (such as
equities). Consequently, when stocks fall, having
The sensitivity of a bond’s price to interest rate
a large amount of cash in a fund offers protection
changes is measured in duration. This incorporates
from volatility.
a bond’s yield, coupon, and maturity, and is expressed
as a number of years. 3 Protection against crisis: Cash is the safest asset
When a yield curve inverts, it is often seen as a leading of all, making it invaluable when political and
recession indicator. An inversion means that yields economic uncertainty presents itself.
on short-term bonds are higher than those of long-term
bonds, and suggests that investors expect interest Remaining invested is crucial
rates to decline in the future, possibly in tandem with Interest rates are close to their lowest level in history,
a slowing economy and lower inflation. meaning that saving money offers no worthwhile return.
However, to find the “real” interest rate, you have
Alternative Instruments to adjust it for inflation. Before the financial crisis,
Many assets, such as precious metals, art, wine, interest rates were higher than inflation – you could leave
antiques, coins, real estate, commodities and private your money in the bank, go for lunch, and when you
equity, are classified as alternative assets. Due to their returned your wealth would have increased (however
unique nature, these assets tend not to correlate with slightly). However, when interest rates are below inflation,
traditional asset classes, meaning they may be suitable every month you leave your money in the bank makes
to diversify portfolios. you poorer in real terms.

FIXED INCOME - THE LOWER RISK OPTION? | 18

9: Investment
management approaches

INVESTMENT MANAGEMENT APPROACHES | 19

Active management: where an investor pays Passive fund management
a professional to actively select investments, Passive funds mirror an index or market, looking to perfectly
attempting to beat the market and minimise losses. replicate its performance rather than beat it, and will either
contain an exact replica of the index in their portfolio or
Active managers use analytical research techniques,
a representative sample of it. Investors can access passive
such as bottom-up and top-down research to buy,
investment approaches through exchange-traded funds
sell and hold securities. Active management can be
(ETFs), unit trusts or open-ended investment companies
undertaken by individuals (single manager), co-managers,
(OEICs). ETFs trade like a common stock on a stock
or teams of investment specialists. Actively managed
exchange, whereas tracker funds (which are essentially
funds track their performance against a benchmark,
the same as ETFs) can only be traded once a day.
and look to deliver better returns.
Factor Investing is a modern technique which
Key advantages: systematically recreates traditional portfolios through the use
of low cost, exchange traded instruments. Factor investing
Active managers can use highly regarded research
considers underlying factors that determine the risks
for investment ideas which can give them an edge over
associated with asset classes, such as the price trends of the
the wider market when it comes to stock picking. They can
equity market, a company’s size, or a bond’s sensitivity to
also minimise losses by avoiding certain investments.
interest rates. This approach delivers a more comprehensive
picture with greater accuracy. Factor investing peers into the
Key disadvantages:
market’s underlying nature, and goes way beyond a basic
The major disadvantage with actively managed funds is understanding of asset classes.
that it can be expensive to work with professionals and pay
A few examples of different factor investing styles are:
for their in-depth research. Particularly when style bias can
Liquidity (this strategy compensates investors who put their
sometimes limit performance, and there is no guarantee
money in less liquid, and thereby riskier, assets. The strategy
that managers will always pick a “winner”.
is usually executed through the buying of illiquid assets).
Active managers use a number of investment styles: Momentum (this strategy relies on short-term fluctuations
Top-down looks at the macroeconomic factors first, focusing in a security’s price, rather than its fundamental value.
on the economic big picture, whereas bottom-up considers Put simply, momentum investors look to buy expensive
microeconomic factors first, such as the health of individual shares and sell them when they become even more
companies. Non-directional funds attempt to deliver expensive. The Carry Trade (this strategy makes use of low
consistently stable returns regardless of market performance. interest rates to borrow, then investing the money in an asset
which provides a higher yield).
Inefficient markets, such as emerging markets or smaller
companies, are often better accessed via active managers, Compounding is the practice of continually reinvesting both
who can use their professional skills to compensate capital growth and interest, creating an ever-increasing base
for the lower coverage of investment banking research, on top of which accumulated assets can grow over time.
geographic, cultural, and language barriers, and unorthodox
business models. This gives them insights that other market
participants do not have, letting them generate additional
returns. The cost of tracking less-liquid markets is also
higher than for efficient markets, driving down the cost
differential between active and passive management.

A mutual fund is a pool of funds collected from individual

investors to invest in securities such as stocks, bonds,
cash, or funds. They can be active, passive, or a mixture
of the two. A mutual fund can be thought of as a corporation
that brings investors together and invests their money as
one lump sum. These funds are managed by an investment
manager, who works to deliver capital gains and income.
Each mutual fund comes with pre-defined investment
objectives which it is structured to deliver.

INVESTMENT MANAGEMENT APPROACHES | 20

Performance Measures Other Relevant Performance Terms:
Alpha equals the percentage of a return Hurdle rate - This mechanism sets a minimum
which is down to the manager’s skill. rate of return to achieve before a fund manager receives
compensation (i.e.: a fee) and offers investors protection
Beta a comparison between the volatility of
from underperforming investment professionals.
a portfolio’s returns and that of the market index.
Beta represents the extent to which a security’s High-water mark - Generally used in the context
returns respond to market swings. In other words, of performance-based fund management compensation.
Beta provides an indication of what kinds Similar to a hurdle rate, managers must get the fund
of movement investors should expect from above the high-water mark before receiving
a security when the broader market rises or falls. a performance fee on the assets under management.

An investment’s volatility is the variability of its

individual returns, over a certain period of time,
relative to its average return over the same period.
It is a measure of how predictable an investment’s
returns are. The higher the volatility, the more a security’s
value can quickly show dramatic jumps and drops.
Conversely, lower volatility means a security’s value
is more stable, and changes at a steady pace over
a longer period of time.

The Sharpe ratio is a comparison of a portfolio’s

return versus a risk-free return. It shows the average
return an investment delivers for each unit of risk over
and above the risk free return that serves as basis for
comparison. The greater the Sharpe ratio, the more an
investment is returning for each unit of risk. Because
a Sharpe ratio calculation just returns a raw number,
it is mostly used in comparison to other funds’ Sharpe
ratios. This measure has become the industry standard
for risk-adjusted comparisons between investments.

INVESTMENT MANAGEMENT APPROACHES | 21