Mutual Funds Glossary

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American Depository Receipt: Known as ADRs, these financial instruments provide a means for foreign companies to sell their stock on the U.S. stock exchanges, all-be-it indirectly. Foreign companies willing to provide financial disclosure on a par with domestic firms can deposit shares of their stock in accounts with participating U.S. banks who then issue ADRs that are sold to investors on the domestic stock exchanges. So ADRs are securities whose underlying value are the shares on deposit with the banks that issued the ADRs.

ADR: See American Depository Receipt.

Asset Class: The definition of asset class is dependent upon the context the term is used and often the opinion of the person providing the definition. The most general definition breaks asset classes down by type of investment: stocks, bonds, real estate, commodities, precious metals and collectibles. Others define asset class by market segment, market capitalization and/or investing style. To someone employing a worldwide indexing strategy, the total U.S. stock market, emerging markets debt and international real estate would all be an asset classes.

Beta: Also referred to as market risk or systematic risk. Beta is a measure of volatility that measures that portion of risk that is inherent to all securities in a universe and thus cannot be diversified away. It is the residual risk of a well-diversified portfolio.

Churning: The trading of securities for the sole purpose of generating commissions done on the recommendation of a person licensed to sell securities. Needless to say, this practice is highly unethical.

Commercial Paper: Short-term debt securities issued by corporations. This form of financing is often used to provide working capital equal to any disparity that may exist between current assets and current liabilities. Commercial paper is a major constituent of many money market mutual funds.

Common Stock: Securities representing the ownership of a portion of a corporation's equity. This ownership comes with voting rights but no other rights regarding the management of the corporation.

Convertible Bond: A corporate bond (debt security) that includes an option to convert the bond to common stock on or before a predefined date. Convertible bonds usually have a lower yield than regular corporate bonds, which reflects the value of the option to convert.

Diversification: The allocation of investable funds across a number of unrelated asset classes to minimize an investor's exposure to risk. Diversification is analogous to not putting one's eggs all in one basket. (Diversification is an extremely important concept and is addressed in many places on this Web site. Use Site Search to find all of the references to diversification, diversified, diversify, etc.)

Duration: The standard measure of the interest rate risk of a bond. Duration reflects the interest rate sensitivity of a bond. In essence, it is a dollar weighted time to maturity based on the present value of the cash flows discounted at the yield to maturity (YTM). The duration of a portfolio of bonds is simply the weighted average of the durations of the bonds held in the portfolio. An example computation can be found in the Mutual Fund Risk subsection.

Efficient: In investing, efficiency refers to an optimal allocation of capital across a pool of assets. For the feasible range of risk for the pool, there is an optimal allocation for every level of risk. These optimal allocations are said to be mean-variance (M-V) efficient per modern portfolio theory as described my Harry Markowitz in 1952. This is discussed in the subsection entitled The Efficient Frontier.

ETF: Exchange Traded Funds are investment companies that own pools of securities that form the underlying value of the funds' shares, and whose shares are traded like shares of common stock. These funds are usually, but not necessarily, designed to track specific indexes of stocks, bonds or commodities. The primary advantage of Exchange Traded Funds over regular mutual funds is that investors can exercise more control over the timing of capital gains and, thus, the incurrence of the associated tax liability.

ETN: Exchange Traded Notes are debt securities whose performance is based on an underlying index, but their value at any given time is determined in part by the creditworthiness of the issuers, thus default risk is an issue and changes in the issuers' credit ratings will be reflected in the ETNs face value. ETNs trade on the major exchanges like ETFs. However, ETNs can be held to maturity just like a bond.

Excess Return: Investing returns in excess of the risk-free rate of return. Short-term U.S. Treasury T-Bills are usually used as a proxy for the risk-free rate.

Expense Ratio: The combined cost of a mutual fund's management and administrative costs, its outside investment advisors, and the 12b-1 fee if one is charged. These costs are deducted from the fund's NAV incrementally throughout the year and are thus reflected in the fund's NAV. Trading costs incurred due to turnover also are deducted from NAV but they are not a component of the expense ratio.

Index Mutual Fund: A passively managed mutual fund designed to replicate the performance of an index such as the S&P 500 or the Russell 2000.

Intrinsic Value: The fair or true value of a security. Intrinsic value is usually determined quantitatively by a discounted cash flow model and quite often adjusted by analysts using various qualitative factors.

Investment Horizon: The period of time an investor uses for financial planning purposes. This is often referred to as the holding period. An investor may have incremental investment horizons that are defined by different stages of the investor's life, such as pre-retirement and post-retirement.

Investment Universe: An investment universe is a set of asset classes to which investing or the analysis of portfolios is restricted. Theoretically, all publicly traded assets worldwide make up the total investment universe. However, most individuals and institutions limit their universes to something less that the total universe. The investment choices available through a 401k plan would define the universe for participants in the plan to the extent that they are invested in the plan but they could expand their universes by investing other funds outside the plan. The asset classes in a universe define that universe on a market-capitalization-weighted basis.

Investment Vehicle: Financial instruments used as a means of attaining one's financial goals. Usually securities of one sort or another.

Load: A sales commission charged on the sale of mutual funds. Loads are stated as a percent of the total amount paid, thus the amount invested is less than the amount paid. Load funds and the effects of loads are discussed in No Load Mutual Funds vs Load Mutual Funds.

Market Capitalization: The total market value of publicly traded securities outstanding. A company's market capitalization is the number of shares outstanding times the current market price per share. The total market capitalization of a segment of the world stock market is the aggregate market capitalization of all the publicly traded firms within that segment. For example: the total market capitalization of the U.S. stock markets would be the aggregate market capitalization of all publicly traded U.S. Firms. The market capitalization brackets are defined in Mutual Fund Classification Criteria and discussed further in The Categorization of Stock Funds.

Market Maker: A brokerage firm that provides liquidity to an electronic stock exchange, such as the NASDAQ, by executing buy and sell orders for stocks in which it makes a market. Market makers are said to make a market in the stocks in which they specialize and provide liquidity to the market by keeping an inventory of those stocks in which it makes a market. The inventory is used to fulfill buy orders in excess of sell orders and to absorb sell orders in excess of buy orders. Market makers are compensated by the bid-ask spread on the trades they execute. Specialists are the equivalent of market makers on the physical stock exchanges.

Market Portfolio: A theoretical portfolio comprised of all of the securities available to investors in a particular market, such as the total U.S. stock market, with the weighting of each security in the portfolio being its market capitalization divided by the aggregate market capitalization of all the securities in the market, i.e., it is market capitalization-weighted portfolio.

Market Risk: Also referred to as systematic risk or beta. Market risk is that portion of risk that is inherent to all securities in a universe and thus cannot be diversified away. It is the residual risk of a well-diversified portfolio.

Market Specialist: Commonly referred to as specialists. Market specialists are firms that hold inventories of the stocks of companies in which they specialize and stand ready to absorb any imbalances between buy and sell orders on the physical stock exchanges, thus providing liquidity to the markets. When buy orders exceed sell orders, the specialists fill those orders from their inventories. When sell orders exceed buy orders, the specialists purchase the excess and add those shares to their inventories. Specialists are compensated for this by the bid-ask spread on the trades they handle.

Mutual Fund: An investment company that purchases a portfolio of securities that conform with its prospectus then sells shares of the portfolio to investors. After the initial pool of securities has been sold, additional shares are created to accommodate additional purchases and the proceeds of those sales are invested in similar securities, thus expanding the portfolio in direct proportion to the sale of additional shares.

NAV: See net asset value.

Net Asset Value: The value of a mutual fund's assets, including both cash and securities, computed at the close of trading on the NY Stock Exchange at 4:00 PM EST on each business day. The net asset value, or NAV, is quoted per share outstanding and is the per-share price of a mutual fund's shares.

No Load: Indicates that a mutual fund is sold without a sales commission. No load mutual funds are compared to load mutual funds in No Load Mutual Funds vs Load Mutual Funds.

Passive Investing: An investing strategy that relies on the use of index funds in lieu of actively managed funds. Thus passive investors' only decisions are which asset classes to hold and in what proportions.

Passive Investor: 1) A passive investor is one who does not participate in the management of the firms in which they have invested by purchasing stock, bonds or shares of limited partnerships either directly or through the purchase of mutual fund shares. 2) An investor who employs a passive investing strategy.

Passively Managed: Index funds are managed passively in that no securities analysis or investing decisions are required by the funds' managers, as their mission is to replicate the performance of established indexes.

Preferred Stock: A class of stock that is a notch above common stock in that, in the event of there being a shortfall of funds available to pay dividends, preferred dividends will be paid first and the remaining funds, if there are any, will then be used to pay dividends to the owners of common stock. In the event of liquidation, preferred shareholders' claims on the firm's assets take precedence over common shareholders' claim on the firm's assets. In the hierarchy of stakeholders, preferred stock falls between bonds and common stock.

Prospectus: In reference to mutual funds, the prospectus is both a book of rules by which a mutual fund must be managed and a means of communicating basic information about a mutual fund's management, managers, fees, past performance and holdings to current and prospective shareholders.

Proxy: In investing, the term proxy refers to something used as an estimate for the purpose of quantifying something for which there is no readily available or meaningful basis for an estimate of its value. An example would be the use of the short-term T-Bill rate as a proxy for the risk-free rate of return.

Risk: In investing, risk is the possibility that an investor will lose all or a portion of their investment or realize a lower rate of return than that which was expected. Investing risk is quantified by measures of the volatility of returns. (You'll find risk addressed throughout this site, particularly in the following subsections: Investment Risk, Market Risk, Mutual Fund Risk and Risk-to-Return.

Risk-Free Rate of Return: The baseline from which the returns of all risky investments are measured. This is based on the notion that there is a risk-free rate of return embedded in the return of all risky investments. Short-term T-Bills are usually used as a proxy for the risk-free rate, although even they include an inflation premium, all-be-it nearly insignificant.

SEC: The U.S. Securities and Exchange Commission. The SEC regulates the creation, registration, sale and trading of securities in the United States.

Sector Fund: A mutual fund that invests in the securities of a specific industry, industry sector or subsector.

Securities: Financial instruments representing a claim on the assets of some entity, such as a corporation of government. Securities can be debt (bonds), equity (stock) or derivative (derives its value from some underlying asset). Mutual fund shares are securities in that they represent the ownership of a portion a portfolio of securities.

Specialist: See market specialist.

Specialty Fund: See sector fund.

Specific Risk: The risk which is specific to an individual firm and which can be diversified away by holding a very broadly diversified portfolio of securities.

Standard Deviation: A statistical measure of variability used in investing to measure risk. The standard deviation is the square root of the variance. (Refer to the sections on risk, performance and comparing mutual funds for the use of the standard deviation in investing.)

Systematic Risk: Also referred to as market risk or beta. Systematic risk is that portion of risk that is inherent to all securities in a universe and thus cannot be diversified away. It is the residual risk of a well-diversified portfolio.

TIPS: Treasury Inflation-Protected Securities, TIPS, are bonds issued by the U.S. Treasury whose principal is indexed for inflation. As the principal varies in direct proportion to inflation, interest payments increase with inflation as does the eventual repayment of principal.

Terminal Wealth Dispersion: the probable range of the value of a portfolio at the end of its planned holding period given assumed values of average annual returns and the standard deviation of returns.

TWD: See Terminal Wealth Dispersion.

Universe: See Investment Universe.

Unwind: To sell off a large position in a security incrementally, usually so as not to affect the market price of the security whose position is being unwound.

Well-Diversified Portfolio: A well-diversified portfolio is one that is exposed only to market risk within asset classes and includes a variety of significantly different asset classes, i.e., asset classes that are not highly correlated and are thus considered to be complementary. The lesser the degree of correlation between asset classes, the higher the degree of diversification and the lower the number of asset classes required to be well-diversified. (Market risk within an asset class is defined as the standard deviation or beta of the of the underlying index of the asset class.)

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