Glossary

A

12b-1 fees

Annually charged marketing/distribution fee on mutual fund shares. They are most often used to reimburse the original salesperson (i.e. marketing), though some 12b-1 fees are paid to the custodian (i.e. distribution). 12b-1 fees are named for the section of legislation that provides for them, and typically range from 0.25% to 1.0%. These fees are included in the fund’s expense ratio, rather than charged separately, and have become more common as loads fall out of favor.

Accredited Investor

A person, trust, or institution eligible to invest in companies exempt from SEC registration (e.g. hedge fund) because they meet a standard outlined in Regulation D of the Securities Act of 1933.
Eligible individuals would have a net worth over $1,000,000 (single or joint) at the time of investment, and/or consistently earn over $200,000 a year ($300,000 a year jointly). Certain organizations (e.g. charity) with over $5 million in assets would also be eligible, along with insurance companies and other professional entities. Since minimal disclosure offers the SEC less opportunity to spot any wrongdoing, accredited investors are expected to conduct their own due diligence on these investment opportunities. They are presumed to be sophisticated enough to understand the strategy in which they are investing.

Actively Managed Fund

A mutual fund whose managers seek to “beat” their benchmark, by purchasing securities they think will perform better than the benchmark, and not purchasing those they think will perform worse than the benchmark. Compare to: index fund.

Alternative Investments

An asset class that includes investments intended to behave differently from stocks, bonds, and cash. More precisely, the primary goal of alternative investments is to have a low correlation with these traditional asset classes, so their inclusion in a portfolio lowers its overall investment risk. The alternative investment itself may invest in stocks, bonds, and cash, but with techniques like derivatives that alter the performance behavior as a whole. Hedge funds are a good example of this. Real estate and commodities are also considered alternative investments.

Asset Allocation

The division of a portfolio’s value among various asset classes. Studies have shown asset allocation, not security selection or market timing, to be the primary determinant of how a portfolio performs over time. The proportion of stocks relative to bonds and cash increases with expected risk and return, i.e. a portfolio with 80% in stocks will fluctuate in value more and over the long-term earn more than a portfolio with 40% in stocks.

Asset Class

A group of assets that share risk factors and expected return. In the broadest sense, asset classes are stocks, bonds, cash, and alternative investments. They are typically more tightly defined (e.g. large U.S. stocks, small emerging market stocks, foreign bonds, U.S. real estate, commodities).

B

Benchmark

An index or combination of indexes, used to gauge the performance of a mutual fund or investment manager investing in the same type of securities. For example, a mutual fund that invests in large U.S. stocks should be compared to the Standard & Poor’s (S&P) 500, which is an index of the largest U.S. companies. A balanced fund, however, which invests 60% in all types of U.S. stocks and 40% in U.S. bonds, should be compared to a proportionate “blend” of indexes, factoring in the broader U.S. market as well as the bond exposure. It is not useful to compare performance between dissimilar asset classes, since the manager has no control over the asset class performance, only his/her choices. Consider a manager who earns 15%, in a year where emerging market stocks on average earn 30%, and the S&P 500 earns 10%. If the fund invests in large U.S. companies, it has done quite well, but if it invests in emerging market stocks, it has done very poorly.

Bond

An investment denoting debt, rather than ownership. For instance, a corporate bond offers a regular payment from the company to the bondholder, who will not receive any benefit from the company’s rise in stock price. The bondholder will also not suffer from a fall in stock price, as long as the company has the means to pay the bond interest. (In a bankruptcy situation, bondholders would also be paid back before common stockholders received a cent.)

C

Correlation

In portfolio management, a statistical measure of how two assets change in value in relation to one another. Those with a correlation of +1 move together in lockstep, while those with a correlation of -1 would move exactly opposite one another. Assets with a correlation of 0 move independently of each other-that is, there is no relationship. In reality, most assets are positively correlated to some extent, and correlations change over time.

As an example of why having uncorrelated assets is helpful to your portfolio, consider Assets A and B. They have the same expected return, but move opposite one another (i.e. they have a correlation of -1, where Asset A goes up in value as much as Asset B goes down in value, and vice versa). By dividing your investment evenly between these two assets, you would have a steady, risk-free return. Putting all of your funds into either asset alone will not, over time, earn you more of a return, it will simply cause much greater fluctuations. Imagine you own a store on an island, where it is either very sunny or pouring rain. Would you rather stock only sunscreen, only raincoats, or both? Selling both makes more sense if you want to make money regardless of the weather.

Commission

The fee paid to brokers to buy or sell a security on an exchange. In the case of full-service brokers, who offer research and trading advice, this is typically calculated as a percentage of the transaction’s dollar value. Discount brokers usually charge flat transaction fees for customer-directed trades.

D

Diversification

The practice of spreading investment funds among various asset classes, which behave differently from one another over time. It is the financial equivalent of the old saying: “Don’t put all your eggs in one basket.” Harry Markowitz pioneered the concept with Modern Portfolio Theory in the 1950s. In short, diversification allows you to reduce your overall risk more than your return, and has been called “the only free lunch in investing.”

Dollar Cost Averaging

The practice of regularly investing a fixed amount, with the goal of reducing the average cost of shares. The fixed amount will purchase more shares when the price is lower, and fewer shares when the price is higher.  An autoinvest program, where you have a chosen amount automatically deducted from your paycheck or bank account, is a helpful way to implement dollar cost averaging.

E

ETF / ETN

(Exchange-Traded Fund / Note) An exchange-traded fund is like a closed-end mutual fund (i.e. traded on an exchange) that is based on some type of index. (The ETN variation is similar, but technically a “debt” instrument of the issuer. This means the issuer’s financial strength should be an additional consideration when purchasing an ETN.)

Theoretically, the ETF/ETN is more tax-efficient and inexpensive to operate than an open-end mutual fund, because it doesn’t do bookkeeping for individual customer accounts or manage daily purchases and redemptions. It avoids this because investors can buy from and sell to other investors all day long, paying trading commissions each time to their custodian/broker. By comparison, open-end mutual funds settle all requested purchases and sales once each day, often with no trading commissions, unless the fundowner’s custodian charges transaction fees on the fund.

Expense Ratio

The operating expenses of a mutual fund or similar security, combined with any 12b-1 fees. An expense ratio is noted as a percentage, and essentially is deducted from the overall investment return. For example, if a mutual fund charges a 1.25% expense ratio, and its investments earn 9.25% in a given year, the investors earn an 8% return. (This assumes no purchases or redemptions during the year.) If the same fund’s investments lose 2.0% in a year, the investors would earn -3.25%.
Other expenses to consider are commissions or loads (charged by non-fee-only advisors), and transaction fees (charged by fee-only advisors’ custodians to execute trades).

For more information on mutual fund fees, check out the Investment Company Institute’s Investor Awareness series (PDF).

F

Fee-Based

An advisor fee structure which involves fees paid by client for the initial financial plan, and upon implementation includes compensation from commissions or sales loads.

Fee-Only

An advisor fee structure where the only compensation received is paid by the client, whether on an hourly/retainer basis or as a percentage of assets under management. The advisor accepts no commissions or sales loads based on the investment products recommended to the client, eliminating potential conflicts of interest.
Clarity Investments + Planning LLC is a fee-only advisor.

Fiduciary

One to whom property or power is entrusted for the benefit of another. A fiduciary standard requires that the beneficiary’s interests are put before those of the fiduciary (or the fiduciary’s employer). This is the standard Registered Investment Advisors like Clarity are held to under the Advisers Act, which is enforced by the SEC.

G

H

Hedge Fund

A loosely regulated investment fund not required to register with the SEC, and example of an alternative investment. Like a mutual fund, it pools investors’ money, but unlike a mutual fund, it can use a broader range of strategies. The ‘hedge’ part comes from the traditional focus of these funds on managing risk, while aiming for a steady (if lower) positive return compared to a typical stock fund’s large fluctuations. Hedge fund managers typically charge a management fee (similar to an expense ratio) and take a percentage of any profit (usu. 20%). They generally have limited redemption opportunities, such as quarterly or annually only. This is to avoid managing constant inflows and outflows and offers more investment flexibility. While lightly regulated, hedge fund managers are still considered fiduciaries, so they can be prosecuted for behavior that misleads or defrauds investors.

Hedge funds don’t have to offer regulators or investors much information on their activities, and for that reason hedge funds can only accept accredited investors. Many investors can only access hedge funds through a “hedge fund of funds,” which adds an additional expense layer for the intermediary, but generally offer lower minimums and more liberal redemption rules.

I

Index Fund

A mutual fund that is invested according to an “index,” or statistical measure of change in a securities market. A popular index is the S&P 500, which is a compilation of 500 large U.S. companies. Standard & Poor’s determines this index’s holdings, making changes as needed due to market events (e.g. a bankruptcy or merger). It is a market-weighted index, where the amount of each company in the index is proportionate to its value in the market. If you think of the index as a shopping list, all S&P 500 index fund managers buy using this same list.

The only difference between two index funds tracking the same index is their expense ratio. Index funds with more efficient trading techniques or more assets to manage can charge less than a smaller or less-efficient fund. As index funds are not trying to “beat” the market, they should have lower research and personnel costs than an actively managed fund.

J

K

L

Load

A transaction fee paid to an advisor based on the mutual fund recommended and purchased. They differ based on the “share class” of the fund, as well as from fund family to fund family. This means the broker’s income will be higher if you purchase certain funds compared to others, based on the fee structure.

Typically the Class A share charges a load upfront, which varies but averaged 5.3% in 2007 for a stock fund (ICI Factbook 2008). Using that average, this means that of a $10,000 investment, only $9,497 is actually invested in the fund. The other $503 ($9,497 x 5.3%) is paid as a sales charge. This share class usually has the lowest annual expenses, however, which make it more attractive the longer the investor holds it. Also, the load may be reduced if the investment is large enough to qualify for “breakpoints,” which vary but commonly begin at $25,000. This is the least suitable share class for short-term investments.

Class B shares would invest the full $10,000, but would then deduct a fee upon the sale. This “contingent deferred sales charge” would vary depending on how long the shares were held, usually disappearing after about 6 years. In the meantime, the B shares would charge a higher annual expense ratio than the Class A shares, because of 12b- 1 fees. The B shares typically convert to A shares a few years after the redemption fee period ends, lowering annual costs at that time. B shares generally are the best share class for medium-term holding periods of several years.

Class C shares are similar to B shares, with a shorter redemption fee period (usually 1 year) and higher annual expenses. This is the share class most suited to short- term investments, and least suited to very long-term holding periods.

There are additional disadvantages to sales charges, besides the cost itself. If the fund is performing poorly, you may want to change investment choices or strategy. In selling your fund shares, you will not get back any of the Class A front-end load, and may pay a high back-end load on Class B shares. You may then pay yet another front-end load, or restart the clock on new B shares, depending on the new investment choice. These sales charges reduce your flexibility to adjust your portfolio, in addition to eating into returns.

For more information on mutual fund fees, check out the Investment Company Institute’s Investor Awareness series.

M

Market Timing

The strategy of getting in and out of the markets in time to miss declines and participate in the gains. While the theory is simple, the execution is virtually impossible over the long term. Even if you sell stocks in time to miss a significant decline, you still have to time your re-entry correctly. The very nature of markets is that they are unpredictable, and historically they have often experienced very swift rebounds after a “bear” market. As individual investors have typically invested more money near market peaks, and far less at market bottoms, the average investor’s track record in market timing is not encouraging. Consider that Dalbar Inc.’s 2008 “Quantitative Analysis of Investment Behavior” shows that in the 20 years ending on December 31, 2007, the average stock mutual fund investor earned only 4.48%, vs. 11.81% for the S&P 500 (large U.S. company index).

With a $10,000 initial investment, that translates to the difference between having about $24,000 instead of $93,000 twenty years later. (Note that you cannot invest directly in an index, but you could achieve similar results with an index fund.)

Clarity Investments + Planning LLC does not utilize market timing.

Mutual Fund

A pool of many investors’ money used to purchase stocks, bonds, or other securities on their behalf.
It is managed by an investment company regulated by the SEC, primarily under the Investment Company Act of 1940. The company is paid for its services via the fund’s expense ratio. Mutual funds differ in strategy, cost, risk and investment holdings – a prospectus will explain these in more detail. As an example, a mutual fund that invests in U.S. stock may be an “index” fund or actively managed fund.

“Open-end” mutual funds do not have a fixed number of shares, and are purchased and redeemed at NAV directly from the managing company. “Closed-end” mutual funds have a fixed number of shares which are bought and sold on an exchange between investors (generally not at NAV). Mutual funds may be sold with a load, which increases its cost to the investor, or not (i.e. no-load mutual fund).

N

NAV

(Net Asset Value) Put simply, a mutual fund’s share price, but technically the value of a mutual fund’s net assets divided by the number of shares outstanding.

It is calculated at the close of trading, so all of an “open-end” mutual fund’s purchase and sell orders submitted that day are filled at the same price. As “closed-end” mutual funds trade on an exchange, with investor demand determining the price, they may trade at a price higher than the NAV (a “premium”) or lower than the NAV (a “discount”).

Negotiated Transaction Fee Schedule

Fidelity, as a custodian, charges transaction fees on certain mutual funds and all trades on an exchange. Our negotiated transaction fees are $25 for transaction-fee mutual funds and a base $12.95 for exchange-based trades. For comparison, see a retail Fidelity customer’s transaction fee schedule.

O

P

Publicly-Traded Company

A company owned by shareholders who can buy and sell their shares on an exchange.
Most large companies are publicly traded, as it offers more opportunities to raise money for growth purposes. It also requires disclosure and oversight by the SEC, as its job is to protect investors; these limit management’s flexibility and increase costs. The alternative is to be privately-owned, where management retains more control and avoids disclosure burdens but has less access to investors. Publicly-traded companies may “go private” when a large investor (like a hedge fund) successfully purchases the entire enterprise from its shareholders.

Prospectus

Formal written document to sell securities that describes the plan for a proposed business enterprise, or the facts concerning an existing one, that an investor needs to make an informed decision. Prospectuses are used by mutual funds to describe fund objectives, risks, and other essential information.

Q

R

S

Sales Charge

The fee charged by a mutual fund at purchase of shares, usually payable as a commission to a marketing agent, such as a financial adviser, who is thus compensated for assistance to a purchaser. It represents the difference, if any, between the share purchase price and the share net asset value. See Load.

SEC

(Securities & Exchange Commission) A federal regulatory agency charged with the protection of investors against fraud and other market manipulation.

It enforces securities legislation such as the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940. (It’s no coincidence these all came about after the 1929 market crash, in efforts to avoid a recurrence.) These laws primarily relate to investment management entities, such as mutual fund companies and Registered Investment Advisors like Clarity Investments + Planning LLC. The SEC also oversees publicly-traded companies for proper disclosure of their financial information.

Security Selection

Also known as “stockpicking.” The strategy of investing in certain securities, believing they will outperform the relevant benchmark, and not investing in others, believing they will underperform. Actively managed mutual funds are based on this approach. Numerous academic studies have focused on whether security selection works. They have basically come to the conclusion that while some managers “beat the market” in the short term, over the long term their numbers are minuscule. There is the additional issue of being able to identify these managers in advance, which is not possible to do empirically. Also, security selection entails higher trading and research expenses, which act as another hurdle to overcome in attempting to outperform the market. Other academic studies have shown that security selection on its own is responsible for a very small portion of investor returns (asset allocation accounts for nearly all of it).

Clarity Investments + Planning LLC does not utilize individual security selection.

Stock

An asset class, sometimes called “equities” because they denote ownership in a company. Common stockholders essentially “own” a piece of the underlying company. They benefit from any dividends and increases in share price, but are also last to be compensated in the event of a bankruptcy. (Preferred stock is different from common stock, in that it has some bondlike qualities.)

T

Tax-Loss Harvesting

An investment strategy that locks in a current tax benefit by selling a security which has lost value since purchase. When an investment falls in value, it can be sold as a realized capital loss. This loss can offset realized capital gains with no limitations. If losses exceed gains, the IRS allows a maximum of $3,000 to offset ordinary income, with any additional losses carried forward to the following year(s). For a client with a marginal income tax bracket of 45%, a $3,000 offset to ordinary income would potentially save $1,350 in taxes. To receive this treatment, one must not violate IRS “wash sale” rules prohibiting the purchase of the same or “substantially identical” securities within 30 days of the sale. To keep a desired asset allocation, the investor sells the security and simultaneously buys something similar enough to the original security, but not “substantially identical.” An example might be selling a Standard & Poor’s Smallcap 600 index fund and purchasing a Russell 2000 index fund; both indexes track small company stocks but differ in composition.

U

V

W

X

Y

Z