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Absolute return fund
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This term confuses many people as the name really doesn’t have much to do with what the fund actually is! In fact, this is a term that describes an investment fund which doesn’t try to match any particular stock market index but focuses on achieving a target return which does not depend on the financial markets. A traditional investment manager’s aim is to manage a range of investments in such a way that the return beats a particular index. So if he or she was managing a portfolio of Irish company shares, they would try to beat the return from the ISEQ index.
However, an absolute return fund will usually aim to beat a set return each year, no matter what any particular stock market index does. This might mean that the fund invests in whatever the investment manager thinks will make money at any particular time, or that it can ‘short’ particular investments (this means they will make money if these investments fall in price). However, the most important point is that its return is not supposed to move in the same direction as stock markets.
As an example, an absolute return fund might aim to give a return every year of, say, 5%. In a year when markets are up 20%, this will look like a poor performance. But if markets are down sharply in another year, this type of fund should still produce a return of around 5%, which will look like a good performance.
The benefit to a pension fund of investing in this type of fund is that it will not behave in the same way as more traditional investments. When other investments are doing badly, this one should continue to do well, and when the traditional investments are performing strongly, the absolute return fund should still be able to achieve modest returns. As a result, in overall terms, the risk of the fund is reduced
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Asset allocation
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This is the process where an investment fund is split between different assets, such as shares (equities), bonds, property and so on. So, for example, the asset allocation process might lead to a fund being invested in the following way.
- 20% in government bonds, of which half are invested in eurozone bonds, and half in bonds from the rest of the world,
- 70% in company shares (equities) of which 20% might be in the US, 30% in the eurozone, 10% in Ireland, and 10% in the UK,
- 5% is put into property,
- 5% is left as cash, in other words, placed in a deposit account with a bank.
The decision as to what percentage is to go to what type of asset is called the ‘asset allocation decision’, and is a major responsibility for the investment manger. The decision will be taken based on a number of issues, such as:
- whether those assets are seen as being cheap or expensive at the moment;
- whether economic growth will be strong or weak;
- whether inflation will be rising or falling; and so on.
In the past, this role was very much the job of the investment manager. The trustee decided which investment manager would manage the fund, and the investment manager then took the decisions about which assets to invest in (usually within ranges set by the trustees). That has changed in recent years, with trustees sometimes now deciding how to allocate the funds themselves, with the help of an actuary’s advice about what assets will best match the liabilities (what the fund has to pay out) of the fund. So, for example, they may take a decision that:
- they will give investment manager A 20% of the fund, which will include only Irish company shares;
- investment manager B will have 50% of the fund, to be invested only in government bonds; and
- investment manager C will have the other 30%of the fund, which will invest in property.
Obviously this does make the job of the trustee considerably more complicated, as they can no longer leave it to the professional investment manager to decide how much money to put into each type of asset. Instead they must have the expertise to take those decisions themselves.
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Balanced Manager
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In recent years, investment managers have increasingly become known as either a 'balanced' managers or ‘specialist’ managers. A balanced manager is one who manages a mixed range of assets, including domestic and international company shares, bonds, and properties. Usually a balanced manager will decide, for the pension fund, what percentage of the fund's assets will be invested in which type of investments (see Asset allocation), taking account of how they think each particular type of investment will perform in the future. A fund of investments which is invested in this way is known as a balanced fund. In contrast, a 'specialist' manager, as the name implies, will specialise in investing in a particular type of investments, or perhaps in a range of different investments. For example they might only manage investments in international bonds, or in US company shares. Or, they might have two or three different teams of experts, each specialising in a particular type of investment.
From a pension fund's point of view, a balanced manager is useful in that the investment manager usually decides how much to invest in the different types of investment, something that the investment manager will probably be better qualified to do than anyone else. On the other hand, a specialised manager may be able to get better performance in their own specialist area than a balanced manager.
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Basis point
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This is very simply one-hundredth of a percentage point. So 40 basis points, for example, is equal to 0.4%.
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Benchmark
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Investment managers are generally told that they must try to match, or beat, a particular target. That target is often referred to as the benchmark. So, for example, if an investment manager is managing a range of UK shares, and is told that the aim for those shares is to beat the FTSE index return, the FTSE index is the benchmark they are using.
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Beta
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Until fairly recently, few pension trustees would need to know much about this unless they had a particular interest in the technicalities of investments. However, as jargon spreads like a weed in our industry, this term is being seen more and more often. In fact, this term can have several meanings, depending on the context. But in the meaning which is most often seen by trustees, it simply means the percentage of a change in price of a range of shares which is due to the rise in the market as a whole. If the Beta of the portfolio is exactly equal to 1, then (all other things being equal), all of the move in the portfolio is because of the move in the overall market.
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Bonds
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Bonds are a way in which investors lend to a company or government. Usually, the borrower (the company or Government) announces the interest rate they are willing to pay for their loan, when they will repay it, and various other details.
Investors (you) then decide whether or not to lend the money to the borrower. If you do, you ‘buy’ a bond from the borrower, which represents a form of ‘IOU’ from the borrower to you, with a ‘fixed’ interest rate. In other words, no matter what happens during the term of the bond, the interest the borrower pays you on the loan would stay the same.
That last feature – the fixed-interest rate – is the main factor in looking at how the prices of bonds behave. If interest rates generally rise, bonds will tend to fall in price. This is because the interest rate originally agreed for the IOU will now be less than the ‘going rate’, and so the bond, or IOU, becomes relatively less attractive. On the other hand, if market interest rates are falling, fixed-interest rate bonds become more attractive, and their prices tend to rise.
Another factor which is very important to bond prices is the expected rate of inflation. If you have lent money to a government at a fixed rate of interest of 4% you will be quite happy if inflation stays at 1%. This is because you will be earning a return of considerably more than inflation. But consider what will happen if inflation was to rise to 10%. Suddenly you are losing, as inflation is considerably higher than the return on the loan (bond). So high inflation is bad for bond prices, and low inflation is good.
And, of course, how ‘creditworthy’ the borrower is, is also very important. The rate of interest on a bond is fairly irrelevant if the loan is not repaid because the borrower goes bust! The ‘safer’ a borrower is, the lower the interest rate they will need to pay on their bond, and vice versa. So a bond issued by a company experiencing financial difficulties will always have to pay a far higher interest rate than a bond issued by a government.
In general, investments in bonds are less risky than investments in company shares (equities), but will generally not go up as much over time.
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Cash
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You might well ask why we are including ‘cash’ as an investment term which needs explaining. Surely everyone knows what cash is? Well, yes and no. In ‘the real world’, cash is obviously notes and coins. However, in the investment world, cash never includes notes and coins. Instead it is funds which are held in deposit accounts with banks or other financial institutions. The funds can also sometimes be invested in ‘financial instruments’ which are not deposit accounts in a technical sense, but which behave in the same way (examples include commercial paper and certificates of deposit).
Pension funds will usually hold a minimum level of cash at all times, to meet any short term needs for funds. This amount might be, say, 1% of the total fund. And, if investment managers are concerned about the financial markets, believing that they might fall in the weeks or months ahead, they may sell some shares or some bonds, and place the money in cash instead, to protect against a fall. But over time it would be very unusual for a pension fund to have a large amount of its fund in cash, because long-term statistics suggest strongly that this has been the worst possible investment strategy over the long-term.
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Correlations
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Correlation is a mathematical term which, in English, essentially means the degree to which two or more things move together. For example, the Belgian stock market might have a very high correlation with the German stock market (two neighbouring and similar economies), but the Chinese stock market might have a low correlation with US government bonds (different geographical areas and different types of investment). Investment experts, whether pension trustees or investment managers, generally like to own assets with relatively low correlations to each other. In other words they ‘do not want to put all their eggs in one basket’, and there are endless mathematical models which take many pages of equations to prove that you shouldn’t put all your eggs in one basket!
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Credit rating
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When investors are lending money to a borrower, they obviously will want to know if there is a serious risk of the company or government getting into difficulty and not being able to repay the loan. Independent companies, known as credit rating agencies, examine the accounts of large companies and countries, meet with their managers or the country’s top officials, and assess the prospects for the company or country over the next few years. They then form an opinion about how likely it is that the borrower will be unable to repay its loans. Some examples of credit rating agencies are Standard and Poors (better known, probably, as S&P), Moodys, and Fitch. Usually, the borrowers (companies) which the agencies think are the very strongest receive a credit rating of ‘triple A’, the next best tier of borrowers get a ‘double A’ rating, and so on down to the worst category of borrowers which might be given a ‘single C’ rating. (Bonds with very poor credit ratings are sometimes called ‘junk bonds’).You should pay close attention to these credit ratings when deciding whether to lend money to the borrower or (in the case of a company) whether to buy its shares.
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Custodian
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A custodian, in the investment world, is the company which holds the assets and manages the investment paperwork of a pension fund, and makes sure that the fund really does own what it thinks it does! While investment managers focus on picking the right shares or the right bonds, the custodian makes sure that when the investment manager decides to buy or sell a share or a bond, the right amount of money is paid or received from the right bank account, and the right share certificate goes to or from the right place. They will keep all the records of the investments, collect dividends and interest due to the fund, and help the investment manager prepare items like transaction statements, valuations and so on. They will have offices or agents in nearly all of the stock markets around the world, so that they can process transactions on behalf of the investment managers, and of course will charge their clients for their services.
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Defensive shares
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These are shares in companies which are expected to perform relatively well if the market as a whole does badly. So, for example, a company which sells a discounted brand of toothpaste is not likely to suffer much in an economic recession. Even if people are generally worse off this year than last year, they will probably continue to use and buy toothpaste, especially if it is a discount brand. So the shares in this type of company won’t suffer much in a recession, or at least will suffer much less than a company which sells, say, luxury cars. They represent a good investment when markets are falling – a way of ‘defending’ investments against a fall in the market as a whole.
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Derivatives
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Derivatives are financial products which can be bought or sold either to protect against a loss or to try to make a profit on another asset. So if you own shares, you might buy or sell a derivative to prevent losing money on the shares if the price of the shares was to fall. Some examples include ‘swaps’, ‘options’, ‘futures’ and ‘swaptions’. In terms of a pension fund, they are usually used to protect against loss, rather than used aggressively to make a profit. An example would be if an investment manager feared that there would be a sharp fall in the stock market. Rather than sell all or most of the investments and have to pay stamp duty and broker commissions, then have to buy the investments back again after the fall in the market, the investment manager might decide to buy a derivative that will pay out if the market does fall. The derivative will cost money, of course, but protects the fund against a fall in the market. They could use other derivatives to protect the fund against a fall in an overseas currency.
Basically there are two types of derivatives, those that increase risk and those that reduce risk – almost like an insurance policy. Some extremely complicated derivatives are very high risk, and large amounts of money can be made – or lost! – from small investments. But in most circumstances these derivatives would not be held – indeed are not allowed to be held – in a standard pension fund. Those derivatives that might feature in a pension fund are far simpler, and almost without exception are there to protect the fund against a loss, rather than to try to make a profit.
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Dividends
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Companies will usually – though not always – choose to return part of the profits that they make each year to their shareholders. This is usually set at around one-third of the profits they make each year, but can vary quite considerably from company to company and from country to country. The amount that is paid out to shareholders is called a dividend, and it is usually paid either once or twice a year, direct to the shareholders. To some shareholders, these dividends are very important as they give them an income on their investment in the company. And, once a dividend is paid, it can’t be taken back! Even if the company’s share price falls, you will keep the dividend. So companies with high dividends can be more attractive to some investors than companies with no or low dividends. And it’s generally true to say that companies with high dividends will tend to do better, compared to other companies, when markets are falling.
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Duration
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For investments, duration is a term which describes the level of risk in a range of bonds. The higher the duration, the more the risk, and so the more the price of the investment will rise when bond prices are rising, and the more it will fall when bond prices are falling. Factors which influence the duration of the portfolio include the length of time before the various bonds are due to be cashed in, the interest rates paid on the bonds and whether the bonds are linked to inflation or not.
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Earnings
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This simply means ‘profits’! For reasons now lost in the mists of time, this industry has always used the word ‘earnings’, instead of the simple and straightforward word ‘profits’. We don’t like it, but we’re stuck with it!
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Emerging markets
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These are markets which are in economies which are significantly poorer or less developed than the major international stock markets (US, Japan, Western Europe), or whose rules and regulations prevent international investors from carrying out the same kinds of transactions as in larger markets. In general, emerging markets tend to have stronger economic growth and produce higher stock market returns than developed markets. But they will also usually have considerably higher risk, for a whole range of reasons. While it’s difficult to be too general, it’s probably true to say that they tend to do well compared to developed markets when markets throughout the world are rising, and that they do somewhat worse when world markets are falling. They are usually seen as more risky markets than the developed markets, and for this reason it’s generally a good idea to take a long-term approach when investing there.
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Equities
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This is another classic piece of unnecessary industry jargon, which is simply used to describe company shares. So when you hear the word equities, just think of company shares! There really is no difference.
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Ethical investments
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You may feel uncomfortable about your funds being invested in the shares or bonds of companies which carry out business which you believe are not ethical. Examples would include tobacco companies, cosmetic companies which test products on animals or companies which make weapons or other military hardware. Investment managers often offer you the option to avoid these types of investments, if you invest in an ethical investment fund. The investment manager of this type of fund will not allow unethical investments in the fund, so you know your funds are not being used to support business activities which you are not comfortable with. The decision as to which businesses or industries are unethical and which are ethical is not always straightforward. For this reason, some investment managers pay respected international experts in this field to give them advice. Of course, experts don’t always agree!
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Fixed income
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This term is used to describe any investment that pays a ‘fixed’ interest rate. But in practice, it is almost always used to describe bonds. So, a statement that ‘20% of the total fund was invested in fixed income’ essentially means exactly the same as saying that ‘20% of the total fund was invested in bonds’.
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Fund manager
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This is more or less interchangeable with ‘investment manager’, and means the professional investment company to whom pension fund trustees or individual investors will normally pass responsibility for day-to-day decisions on how the funds are invested. The fund manager or investment manager will buy and sell share, bonds, properties and other investments, and regularly report back to the pension fund trustees, with information about how those investments have performed against a particular measure (or benchmark). This term can also refer to a person working within an investment management company, so that the person managing, say, UK bonds would be referred to as the UK bond fund manager. And the term also has more or less the same meaning as asset manager or portfolio manager.
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Fund of funds
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As the name implies, this is an investment fund which invests in other funds of a particular type. So a hedge fund ‘fund of funds’ is a fund which invests in a number of other hedge funds. The idea is that the fund of funds can take advantage of the investment benefits of (in this case) hedge funds, but can reduce the risk of this investment strategy by owning a small part of lots of different hedge funds, rather than all of just one fund. In plain English, this is simply spreading the eggs so that they are not all in one basket!
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Gearing
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See ‘Leverage’ for an explanation of this term.
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Gilt
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In the past, bonds issued by the UK and Irish governments were known as ‘gilts’, because at one time the paper that the bond certificates were printed on had a gilt edge. (This is where the term ‘gilt-edged’ came from.) But in recent years the term has begun to die out, and the word ‘bond’ has come to replace it, particularly in Ireland.
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Hedge fund
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The term first began to become widespread in the investment industry well over 10 years ago, but it is very difficult to define exactly what a hedge fund is. Indeed, it’s probably easiest to start by saying what it is not! Traditional investment managers usually are ‘long only’ investors. This means that they make profits from buying shares that go up, but they do not aim to sell shares that they do not own to make profits when shares are falling. Also, traditional investment managers do not ‘gear up’ or ‘lever’ (leverage) their investments. If they are given, say, €100million to invest, they buy shares, bonds or properties up to the value of €100million. And traditional investors usually take their decisions based on what they think might happen over the next two years or so, rather than over the very short term.
Hedge funds are different in three main ways. Firstly, they are almost always able to sell shares that they do not own, in the expectation of buying them back later at a lower price, and pocketing the profits. This is called ‘shorting’ the share price. Secondly, they usually gear up the investments. So if they are given €100million to invest, they may use the €100million as security to get a loan of €500million, and they then invest the full €600million (in the same way as a house buyer puts down a deposit of, say, 10% of the value of the house, and gets a mortgage for the other 90% to buy the house or apartment). Thirdly, they generally take a shorter-term view of markets than traditional investors.
Hedge funds are generally perceived to be higher risk than ‘normal’ investments, due to the geared nature of some of the funds, and the shorter-term risks that they take. For this reason they tend to be restricted to very wealthy or experienced investors. However, because hedge funds invest in a very different way to ordinary investment funds, pension funds may be able to reduce the overall risk of their fund by investing in hedge funds at the same time as investing in more ‘standard’ investments.
However, it is unwise to generalise too much about hedge funds, as there are so many of them and they vary so much. For example, some hedge funds are actually quite low risk, and do not gear their investments.
And some are designed to put in place strong protection against losses. Finally, some are open to ‘ordinary’ investors, and of course there are also ‘funds of funds’, which invest in a whole range of hedge funds. Fund of funds offer the advantage that the risks associated with any one hedge fund are significantly diluted so that they are typically used by investors who want to enjoy the benefits of investing in hedge funds without some of the disadvantages.
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Hedging (currency)
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Investment managers will sometimes decide to protect their investments from changes in currencies overseas, which means that they ‘lock in’ the current exchange rate. Obviously, they would only do this if they expected the overseas currency to fall.
As an example, think of an investment manager who has invested, say, 20% of the total fund in US shares, but who expects the US dollar to fall significantly against the euro. The investment manager could sell the US shares, so protecting against the fall of the dollar. But if the shares are cheap, why should they be sold just because the currency is expected to fall? In fact, it may sometimes make more sense to sell the dollar while keeping the US shares. To sell a currency in this way is known as ‘hedging’.
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High-yield fund
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Earlier in this guide we explained what dividends are, and how some investors prefer the shares of companies which pay out high dividends to their shareholders. Because of this, shares which do pay out high dividends can be better investments than those that do not, at least when markets are behaving in certain ways. A high-yield fund is one which invests mostly in shares of companies which pay high dividends, and so investors who invest in this type of fund will benefit if high-dividend shares do well. However, some of these funds can be hurt by the fact that certain types of companies, such as banks and utilities (gas, electricity, phone companies and so on), typically pay higher dividends than other shares. So a high-yield fund could end up owning far more shares in banks and utilities than makes sense.
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Index-linked Bonds
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See ‘inflation-linked bonds’ for an explanation of this term.
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In specie transfer
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When a pension fund transfers to another investment manager, there are two ways of moving the investments. The first is simply for the first investment manager to sell the investments in the markets, and give the money raised by doing this to the second investment manager. However, this involves costs, such as stamp duty, and so is not always the best option. The other way is for the first investment manager to transfer the investments direct to the second investment manager. This involves quite a lot of paperwork, to make sure that all the share certificates, for example, are sent to the new investment manager correctly. However, it is still usually less costly than selling all the investments. This is known as an ‘in specie’ transfer.
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Inflation-linked Bonds
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Bonds are essentially loans to a company or government. The interest rate on that loan is normally set when the bond is issued (in other words, when the loan is made). So if the Irish Government issued a bond, it would announce at the time it issued the bond that the interest rate it would pay on that bond would be, say, 4% a year.
Inflation-linked bonds pay an interest rate which is worked out in a totally different way. The company or government issuing the bond (borrower) announces that the interest to be paid on the bond will be, say, 1% plus the inflation rate for that year. So, if inflation was to be at 5% in any particular year, the interest rate paid that year would be, in this example, 6%. And, the amount the borrower would repay would also rise in line with inflation. So if inflation over the entire period of the bond adds up to a total of 25%, you would get back €125 for every ?100 invested in the bond, as well as getting the interest each year along the way.
These bonds can be very attractive if you have payments you need to make which are likely to rise in line with inflation. By buying these bonds, you can make sure that your assets grow more or less exactly in line with what you have to pay out. However, what a pension fund has to pay out generally grows in line with wage or salary increases (not general inflation) and interest rates, and so index-linked bonds are a not a perfect investment type for pension funds, although clearly they do have significant advantages.
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Investment manager
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See ‘Fund Manager’ for an explanation of this term.
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Investment style
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Investment style is the approach that investment managers take to investing. For example some investment managers believe that investing in the shares of companies with a particular type of characteristic will give the best investment results over time. Because of this, they tend to have a higher-than-average percentage of these investments. The two best known investment styles are ‘growth’ and ‘value’. We explain both in detail elsewhere in this guide.
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Leverage
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This is the process where a small amount of money is used as security, to borrow a much larger amount of money which is then invested. It’s a bit like buying a house. You save the deposit of 10% of the house price, then borrow the other 90% from a bank to buy the house.
It is unusual for pension funds to use leverage within their funds. This is mainly because doing so could put the tax status of the pension fund at risk. So a pension fund with 20 million euro in assets would not be allowed to borrow another 80 million euro and invest the total 100million in the markets! But you may still come across the term from time to time as some of the funds in which a pension fund invests may themselves use leverage within their funds – an obvious example would be hedge funds, which usually do use leverage.
Another word for leverage is ‘gearing’.
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Liability matching
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Pension funds obviously have ‘assets’ and ‘liabilities’. The liabilities are the future pensions that must be paid to members, after taking off an amount to take account of today’s value. The assets are the investments in the fund. The liabilities of the fund will move in line with a combination of salary increases, inflation and interest rates (because interest rates are used to discount future pension payments back to today’s value). The assets will grow in line with investment performance and contributions from the employer. In an ideal world, pension funds would invest in assets which would grow exactly in line with the liabilities. Then, the risk of the assets not being big enough to pay the liabilities would be significantly reduced. If this can be done, the fund is said to have put a ‘liability matching’ strategy into practice.
However, this is a lot easier in theory than in practice. Investments do not exist that will exactly track a mix of salary increases and inflation (which are what decide the increase in pension liabilities). Some governments do issue ‘inflation linked bonds’ but these match general inflation in a country, not salary increases. As salary increases tend to go up more than inflation, these bonds don’t provide perfect liability matching for the pension plan. And, most pension funds will know that they will have to pay pensions up to 40 years or more in the future, but it’s very rare to find bonds which are that long-dated.
A further problem is that in order for liability matching to work, the pension scheme must start from a position where the fund has enough money to pay its future pensions. If a pension scheme has a deficit (does not have enough funds to pay pensions) to begin with, a liability-matching strategy will only ‘freeze’ that deficit in place, which is obviously not good. And, of course, many pension schemes do have deficits at the moment.
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Lifestyle fund
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This is a fund which gradually changes the nature of the investments in a pension fund over time, to take account of the age of the employee. It only applies to defined-contribution pension schemes and AVCs.
Broadly speaking, if a younger person has a pension plan, it should generally invest heavily in company shares, because these assets tend, if history is a guide, to perform better than other assets such as government bonds, property or cash over the long term. But if a person is, say, five years from retirement age, their pension fund should tend to have a much higher percentage of the assets invested in government bonds, because these assets are usually a lot less risky than company shares.
Take the example of a 55-year-old woman who expects to retire at 60. There have been several examples in history of five-year periods during which stock markets actually fell. So this 55-year-old woman would reasonably want to protect herself against a fall in stock markets which would give her a much smaller pension than she now expects. One obvious solution is to put a large part of her fund in bonds, which should mean that any losses will be significantly smaller than if she left all her investment in shares.
But to continue this example, suppose this person just never gets around to changing her investments as she gets nearer retirement age. Maybe she just ‘never gets around to it’, or perhaps she isn’t aware of the changes she should be making. Either way, she is at risk. Lifestyle funds take away this risk by automatically shifting part of her fund into lower-risk assets as she gets older. In this way, she doesn’t have to remember to change her investments – it’s done for her. This is the main advantage of a lifestyle fund.
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Liquidity
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In terms of investments, this means the ability to buy or sell the investment quickly, and without moving the price of the investment as a result. So if a company share is traded very actively, (with many millions of the shares being bought and sold through the stock exchange every day), it will be very easy to buy or sell shares in that company in a matter of minutes, and without moving the price. This type of share is said to be very liquid.
On the other hand, if you try to sell an individual property, it may take several months to find a buyer and get all the paperwork sorted for the transaction. That is why property is said to be illiquid.
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Macro and micro
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We can broadly divide factors which affect investments into two main categories - macro and micro. Macro factors are generally political or economic. So, for example, changes in interest rates, or economic growth, or a change in government that might lead to different economic policies, are all called macro factors. An investment manager which focuses on these factors is often called a ‘top-down’ manager.
Micro factors are anything that is to do with the individual investment. So, in the case of a company, examples would include a change in top management, or a decision by the company to take over another company, or a new product that the company has introduced. An investment manager who believes that these factors are the most important ones when deciding on which investments to buy is often called a ‘bottom-up’ manager.
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Market-neutral
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An investment, or investment strategy, is said to be market-neutral if its success or failure is not related to whether the market, as a whole, rises or falls. In other words, the investment should produce the same return whether the market is up 10% or down 10%.
It’s probably most easy to understand by using an example. Suppose an investment manager runs a ‘market-neutral’ fund, and believes that the best shares to buy are, say, in technology companies. The manager would then buy shares in several technology companies, but would, at the same time, invest in an ‘equal but opposite’ type of investment which pays out if the stock market as a whole goes down, and costs money if the market goes up.
Now imagine that the average performance of the technology companies is up by 25%, while the stock market as a whole rises 20%. Because the stock market has gone up 20%, the fund makes 5%, (the 25% that the technology shares have risen, less the 20% that the stock market has risen). But suppose the stock market had actually fallen 20%, and the technology stocks had fallen 15%. In this example, the fund would lose 15% on the tech shares, but would get back 20% due to the fall in the market, and would still make a profit of 5%. The performance of the overall fund is 5% in both examples, even though in one case the market soared, and in the other it collapsed. This is a ‘market-neutral’ strategy. Many hedge funds fall into this category. The main issue here is that the investment manager must have the skill to choose the right stocks to perform in both rising and falling markets.
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Multi-manager funds
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These are funds which are managed by several different investment managers, rather than just one. The managers are chosen by the ‘manager of managers’, who chooses managers for each part of the fund, based on decisions such as:
- the manager’s recent investment performance;
- the credentials of its main staff members;
- its investment style, and so on.
So, the manager of managers might pick one investment manager who has a very good track record of managing US shares to manage that part of the overall fund, but pick an entirely different manager to manage Japanese shares, and another one again to manage bonds. In this way the pension fund itself gets the ‘best of breed’ manager for each part of its fund, without having to do in-depth research on thousands of investment managers around the world. Needless to say, the manager of managers charges a fee for this service, but many pension funds find it a helpful service.
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Options (also see derivatives)
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In terms of a pension fund, options are a particular type of investment that a manager may most often use to protect assets against a sudden fall in markets. It gives the right, but not the obligation, to sell a basket of shares at a particular price – usually a price quite close to the current level. If the stock market then falls significantly, the right to sell that basket at a level which (after the fall) is now much higher than the current level is worth a lot of money, and should offset the losses on the assets as the market went down. So the fund as a whole is protected against loss. You can also use options to protect against a fall in a currency, or a fall in bond prices, of course. And, it may also be used for an enormous number of other financial transactions. But in terms of a pension fund, they are most often used to protect against a fall in stock markets, as above.
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Overweight or underweight
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An investment manager is said to be ‘overweight’ in a particular investment or type of investment if they have more of that investment than some ‘neutral’ level. So, for example, an investment manager may be told that they are to manage a basket of Irish shares, and try to do better than the return from the ISEQ index. The ISEQ index measures the performance of the entire Irish stock market, with each share having a percentage weight within the index which reflects its size. If the manager believes that, say, Ryanair is a particularly attractive stock, they may invest 20% of the total investments in Ryanair shares. But the weight of Ryanair within the ISEQ index is only around 6%. So the investment manager is clearly ‘overweight’ in Ryanair shares – they have 20% of the fund in Ryanair versus a neutral level of 6%. Underweight is simply the opposite of overweight.
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Passive
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This is an investment strategy where the investment manager simply aims to match (as opposed to beat) the index or benchmark that is set for the fund. In sporting terms, it is ‘aiming for a draw’, as opposed to ‘going for a win’. So, it is most often used when the investment manager, or the pension fund client, believes that current circumstances mean that it will be very difficult to beat the index, and that matching the index will be an acceptable result. It should obviously be easier to match an index than to beat it, and so the fees charged for this kind of product are lower than for active products. Some passive products aim to exactly match the performance of the index to within, say, 0.1%, whereas others don’t or can’t be so exact, but still aim to be as close as possible.
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Private equity
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This generally refers to investments in companies which are not quoted on the stock exchange. These companies fall into two main categories – those that are too small to be on the stock market, and those which are not liked by the stock market and so are bought by private investors and taken off the stock market (a good example of this in Ireland would be eircom).
Particularly in the case of companies which are too new or too small to be quoted on the stock exchange, the risks associated with these investments tend to be quite high, as many of these companies may not make it in the long term. On the other hand, if investors can get in early to companies which become successful, and perhaps float on the stock exchange, they can make a lot of money. These high-risk and high-return investments have traditionally taken up only a small percentage of pension fund investments. For example, in Ireland, less than 1% of total pension fund investments are in these kinds of companies. This is known as venture capital.
There is a different class of private-equity investment, which is far larger in scale. This is where investors look at quite large companies (there is virtually no upper limit) which for one reason or another are not liked by stock markets. This could be because they are in a sector which the market does not like (for example, an oil company if oil prices were exceptionally low), or because the management is not respected, or perhaps there is some other reason. In any case, institutional investors who dominate the stock markets put quite a low price on the company. A private-equity fund may decide that it could buy the entire company, take it off the stock exchange, then perhaps restructure it, or put in new management, and pocket the higher profits that they would expect to create from restructuring the company. They may choose to sell the company back to stock market investors a few years later, after the company is in better shape, or perhaps when that type of company is once again attractive to stock market investors for other reasons.
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Property
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What is there to explain about property in terms of investments? Not that much really! But we should mention that when pension funds invest in property, they can do so in a couple of different ways. They may choose to buy a property or properties direct (in other words, without using an investment manager at all). Or (far more usually) they may choose to have an investment manager manage the property investments of the pension scheme. If so, the investment manager can either buy individual properties outright, or pool together with other investors to buy a number of different properties, so that the risks associated with any one property are diluted. Most pension fund property investment is in offices, shops and warehouses and factories – they do not invest in houses or apartments.
The advantages to a pension fund of investing in property are that:
- it tends to perform quite well over the long term (doing better than government bonds, though not as well as company shares);
- it is not particularly risky over the short-term; and
- it generally provides a good income (through the rent received).
Disadvantages include:
- the exceptionally high costs of buying property (9% stamp duty on Irish properties, plus legal and other costs), and
- the lack of liquidity (company shares can be sold in a matter of minutes, while it could easily take six months to sell a property).
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Qualitative and quantitative
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These are two main methods an investment manager will use when deciding what investments to buy. A qualitative approach is based on human judgement and skill. If an investment manager takes a qualitative approach to deciding whether to buy shares in a company, they will want to assess the company’s management, and will talk to the main staff in the company to see what their growth strategy is, how they will deal with possible problems, and so on. They will also look at the finances of the company, and its valuation. Finally, the investment manager will judge whether to buy shares in the company or not, based on their assessment of the prospects for the share price.
A quantitative approach to investments involves spreadsheets and computers, and very little human opinion. In the extreme it may have no human involvement at all - a computer decides what investments to buy based on the information it receives. The factors which are used in quantitative analysis are many and varied, but include various financial and accounting measures to do with the company’s profits and cash flows, but also a number of other measures looking at how the company’s share price performs and how it measures up compared to other companies.
In practice, most investment managers do not use either extreme. They use both human judgement and skill and mathematical measures to make decisions on investments.
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Record-keeping
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Any pension scheme will have to keep records of its members’ names, salaries, addresses, dates of birth, date of joining the company, and other information. A defined-contribution scheme will also have to keep a record of every contribution made by or for a particular member, together with the type of investment made for each member, and how each investment has performed. For almost all pension schemes, this administrative task is given to another company, often a pension consultancy firm.
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Risk
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It’s hard to know where to begin with this one! The dictionary definition of risk is, “1. Hazard, danger, exposure to mischance or peril, or 2. The chance or hazard of commercial loss”. But in a pension fund, the ultimate risk is the risk that the assets of the pension fund will not be enough to pay the liabilities of the scheme. That ultimate risk can arise in many ways.
- The assets of the pension fund might be stolen by some accounting trick (remember the Maxwell pension scandals?).
- The assets might not be secure if a custodian got into financial difficulties.
- The employer might not be paying enough money into the fund.
- Poor investment returns might mean that there just isn’t enough money to pay the pensions.
Pension fund trustees have to protect their funds against all of these risks and have a legal duty to their members to do so. Not always an easy task!
In the context of a guide like this, it probably makes sense to focus just on ‘investment risk’. This is the risk that the investments of the fund perform so poorly that there are not enough funds in the scheme to pay pensions to the members of the scheme. There are several ways in which this could happen.
Firstly, the investment strategy of the scheme could be too ‘conservative’ to achieve the returns needed. For example, if the entire pension fund was just put in a deposit account for 30 years, it’s highly likely that the fund would not be enough to pay the pensions when they are due.
Secondly, even if the investment strategy is correct, there is a risk that the investment manager hired to carry out that strategy may not perform well enough, and so the investment return would again not be high enough to pay the pensions. This risk is generally called ‘manager risk’, and can be dealt with by carefully choosing the investment manager, or by employing a number of managers, or by following a ‘passive’ investment strategy.
Thirdly, there is ‘market risk’. This is a risk that despite having the right investment strategy, and the right investment manager, investment returns are poor due simply to weak markets. In some ways, this is the hardest risk to avoid. While it is possible to have some investments that don’t move in line with overall markets (see market neutral) it really only makes sense to use this strategy for part of a pension fund. This is because if all the investments do not invest in the overall market, they will not go up with the market over time. And if the investments don’t go up, the pensions don’t get paid! It’s as simple as that. As a result, all most pension funds can do to avoid this risk is to make sure that their fund has a mix of investments, which belong to various different markets, in the expectation that not all markets will fall at the same time. For example, it is generally, though not always, true to say that if shares fall, bonds will rise.
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Shares
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See ‘Equities’ for an explanation of this term.
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Shorting
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Shorting is a method of making money when prices fall. It is generally done by selling an asset, say a company share, that the seller does not own. The seller hopes that when the time comes to buy the share back, it will be at a lower price and they can pocket the difference. Normally pension funds invest for the long-term, and do not allow their investment manager to do this as it will generally only work for short-term trades. But in recent years, pension funds and pension funds investment strategies have become increasingly complicated, and some parts of pension funds are occasionally invested in funds which do use this strategy.
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Stock selection
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This is simply the process which investment managers use to decide which shares they want to buy in a particular market. So if an investment manager is managing a range of Irish company shares, the ‘stock selection’ is simply their decision to own, say, Bank of Ireland shares, but not to own AIB shares. The ways in which these decisions are made can vary. Some are highly complicated, involving complicated mathematical models and equations, and others are just based on ‘instinct’. It is usually said to be the single most important skill that an investment manager needs.
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Stock-specific risk
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This is the risk associated with owning shares in any one company. Obviously, if a pension fund’s total investments are in the shares of only 10 companies, on average each holding is worth 10% of the fund, and the ‘stock-specific risk’ of that holding is very high. If anything was to go very wrong for any one company, leading to a sudden and dramatic fall in the share price, the damage to the overall investments would be quite large. Indeed in a worst-case scenario, 10% of the value of the fund could be lost due to an ‘accident’ involving just one company.
But if the pension fund instead invested in, say, the shares of 500 companies, a disaster with one company could only lead to a loss of 0.2% of the fund – a dramatically lower loss than the 10% loss if the fund only invested in 10 different shares. So, the larger the number of companies that the pension fund invests in, the lower the ‘stock specific risk’ to the fund.
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Valuation
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There are two, quite separate, meanings for this word in terms of investment.
The valuation of a company share means whether it is cheap or expensive, according to various different measures that investment managers use including some you might be familiar with such as P/E ratio and “dividend yield”, as well as other more complicated measures. Obviously, investment managers will prefer to buy the shares of companies whose valuation is cheap, all other things being equal, and will tend to avoid buying the shares of companies whose valuation is expensive.
But ‘valuation’ also means the statement that an investment manager will send to the trustees of a pension fund every month, every three months or every year, giving a list of the investments that have been bought for the fund, and how much those investments are worth at the time that the valuation is drawn up.
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Value
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This term is most often used, in terms of an investment, to describe a particular style or method of investing. In recent years, a significant number of investment managers have described themselves, or have been described, as ‘value managers’. This means that they tend to be biased towards buying shares which can be described as ‘cheap’, using various technical measures of value as a guide. This is because they believe the share prices of these companies will rise by more than other companies. These investment managers would not have all of their investments in ‘value’ companies, but they would have more than other investment managers.
This strategy at first sight seems too obvious to be true. After all, who would want to buy shares that were not cheap? But it does have drawbacks. Sometimes shares are cheap because:
- the management of the company is very poor;
- the business is operating in a sector where it’s very difficult to see much potential for future growth; or
- there are question marks about the company’s accounting policies.
There can be very good reasons for the shares to be cheap, and perhaps the shares might fall even more and get even cheaper! Nonetheless it is an investment strategy which can work well, particularly at certain times during the economic cycle.
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Venture capital fund (also see private equity)
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This is an investment fund which invests in a number of businesses which are small, and which are not (yet) quoted on any stock exchange. Many start-up companies can have excellent business ideas, but they need funds to get the business up and running, firstly, and then to expand it later. If you ‘get in on the ground floor’, in terms of investing at an early stage, these companies can be very profitable and they can be very good investments. But while investment managers have the funds to invest in these businesses, they rarely, if ever, have either the skills or the time to work with these small companies and make a success of them. And of course the risks of investing in these very small companies are far larger than the risk of investing in large, blue-chip companies, as quite a few start-up companies may well end up going bust.
The way around this has been to set up ‘venture capital funds’, which invest in a number of these small companies, using funds given to them by the large investment managers. The managers of these funds will generally have a lot of experience in assessing the prospects for small companies with (potentially) good ideas, and will also be able to work with the companies, advising them on the best strategy they can follow for success. They will know that many of the companies that they invest in will fail, but expect that those that do succeed are likely to make them a lot of money!
In a sense, everyone gains. The pension fund and the investment manager invest in potentially a very lucrative set of investments with a reduced risk and as little inconvenience as possible, while the small companies get the cash that they need, as well as expert advice on how to succeed.
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Volatility
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This is how far an investment will change price, either upwards and downwards. For example, property tends to change price relatively slowly – and moves in one direction for a long time. As a result, its volatility is said to be fairly low. On the other hand, the price of the shares in ‘dot-com’ companies some years ago tended to move very rapidly – both up and down! So those shares were said to have high volatility. To an extent, you could use the word risk instead of volatility – the meaning is much the same. The more volatile or risky an investment, the more money is likely to be either made or lost.
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Yield
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This refers to the dividend paid by a company on its shares, or the interest paid on a bond or bank deposit, or the rent paid on a property. This is almost always expressed as a percentage. So, for example, if AIB’s share price is €20, and it pays a dividend of one euro per share per year, its ‘yield’ would be 5% (one-twentieth). You can also work out a yield for a portfolio as a whole, as a weighted average of the yields of all the individual investments in the portfolio. So a fund that had, say, 70% in shares, with an average yield of 2%, and 20% in bonds, with an average yield of 4%, and 10% in property, with an average yield of 5%, would have a yield for all investments of 2.7% (the weighted average of the three numbers).
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