Key investment terms you should know ALPHA OR BETA

The more you understand, the more confidence you will have to ask the right questions

FOR MANY of us, investing is not something that we deal with in our everyday lives, and it can therefore feel intimidating. Knowing the basic terms, however, can help you to:

◆ Sort through some seemingly complex terminology used in the investment world.

◆ Feel that you know enough to understand the basics of your own investments.

◆ Ask some questions that could significantly increase your understanding of your investments.

CASH, BONDS, PROPERTY AND EQUITIES

Let’s start with basic asset classes. These are the investment building blocks in which your money can be invested. The main asset classes are cash, bonds, property and equities.

◆ Cash is money you have invested in a bank account and on which you earn interest.

◆ A bond is basically a loan that the bondholder has lent to the government or a company. A bond usually pays a fixed rate of interest over a fixed period, and at the end of the period the original amount is paid back to the bondholder.

◆ Property is an investment into “bricks and mortar”, or buildings that will be rented out to deliver a rental income, as well as a potential increase in the value of the underlying property over time.

◆ Equities, or shares, are the certificates that represent partial ownership of a company listed on a stock exchange. Anyone can invest in the company by buying shares. There’s no agreement to repay the amount you invested when you bought the equities (as there is with bonds). You hope to benefit through the dividends that might be paid out to you and through the earnings retained in the company that, over time, should reflect in an increase in the price of the equity or share.

Most investment portfolios are made up of a combination of cash, bonds, property and equities. There are some variations:

◆ The companies underlying the equities are based in South Africa or another region.

◆ The coupons on the bonds are fixed or vary with interest rates or inflation.

◆ The government, a state-owned entity or municipality, or a privately owned company issues the bonds.

LISTED OR UNLISTED

Another key variable that may be introduced into an investment portfolio is whether investments are listed or unlisted.

◆ Listed assets are listed on a stock exchange, and the prices are quoted daily based on the prices agreed by buyers and sellers on the exchange. ◆ Unlisted assets are investments that are not listed on any stock exchange. Their value is determined periodically (for example, quarterly) based on an agreed method of valuing the underlying assets.

Unlisted assets are usually expected to be owned for longer periods. If an investor wants to sell earlier than this period, it is often more difficult to find a buyer and to know in advance what value you will receive if you can sell the assets. However, the price of the unlisted assets is far less variable, and usually you would earn an increased return for being willing to invest over a longer time.

You might also find the terms “public market assets” used to describe listed assets and “private market assets” used to describe unlisted assets that are not listed on public markets. You will often hear people talk about “market beta”. This is the impact of overall market returns on an underlying asset. This means an equity may go up and down in value because of factors that are specific to that equity, such as a good dividend payment, a change in company management or news that is good or bad about the company’s prospects. Often, these individual company factors are swamped by overall market factors. Therefore, equities in a company that is not doing that well may not perform as well as other equities in the market but still increase in value because overall equity values are going up. This overall market impact is called the “market beta”.

“Alpha” measures the extent to which an asset has outperformed or underperformed relative to a market measure, often referred to as an “index”. The market measure will generally be chosen in advance and referred to as the benchmark against which an asset’s performance will be measured. If an asset earns more than the benchmark, it is referred to as having earned alpha relative to that benchmark.

Similarly, when asset managers are appointed to manage an investment portfolio, their performance will be measured against a chosen benchmark. If they have outperformed, they will be described as having added alpha.

ACTIVELY MANAGED OR PASSIVELY MANAGED

This brings us to a topic on which you will see and hear a lot of debate: is it better to choose an actively managed or a passively managed investment strategy?

When you choose an actively managed investment strategy, the asset manager you appoint will choose which assets to hold in your investment portfolio. The manager’s aim will be to deliver investment returns that beat or “add alpha” relative to your chosen benchmark. The managers will actively buy, hold and sell assets to try to achieve this goal.

When you choose a passively managed investment strategy, the asset manager you appoint must invest to deliver a return that tracks as closely as possible to the benchmark that you have selected. Because they are investing in assets only in the weights that they represent in the benchmark, and therefore do not need to invest in research that would help them to make active choices about these assets, passively managed funds will usually charge lower asset management fees than will be charged by managers of actively managed investments.

The key in deciding whether to choose an actively managed or passively managed investment strategy is whether you believe an active asset manager will be able to add sufficient alpha over the benchmark after deducting their asset management fee, compared with a passive asset manager that delivers close to a benchmark return after deducting a lower asset management fee.

Many investors believe that the more efficient a market, and the more that returns in a market are driven by market beta, the more it makes sense to invest at least a portion of assets passively. In less-efficient markets where there are more factors that drive individual asset values (such as investments in less-sophisticated markets or in unlisted assets), it makes more sense to stick to active management.