Active fund
A fund that aims to provide above-average performance by using human judgement and/or quantitative tools to select and trade stocks and asset classes. Active fund managers try to outperform indices or meet specific total return targets. Index fund managers, by contrast, try to match the performance of indices as closely as possible.
Active manager risk
Alternate term: predictive tracking error
Also known as predicted tracking error, active manager risk expresses how much tracking error relative to abenchmark a portfolio manager may produce while attempting to add alpha over and above the benchmark. In this context, tracking error can be quantified as the standard deviation of a manager's alpha to a benchmark. If a manager's benchmark is the S&P 500, and the tracking error of his or her alpha to that benchmark is 5.5%, and assuming a normal distribution, then:
- 2/3 of the time the alpha should fall within a range of +5.5% and -5.5%
- 1/6 of the time positive alpha should be greater than +5.5%
- 1/6 of the time negative alpha should be less than -5.5%
This signifies that the client will experience negative tracking error of -5.5% or more in one out of every six years. Although a client's tolerance for negative alpha in any year is an important consideration in determining a risk budget, their tolerance for this one-in-six-year negative event is especially important.
Active manager risk budget
A subjective, customised goal established to quantify the amount of active manager risk an investor is comfortable assuming. Clients with a low tolerance for active manager risk will tend to allocate more of their assets to index funds to achieve low tracking error. Clients who are less sensitive to tracking error tend to allocate 100% of their investments to active managers. Risk budgeting is a process that usually combines index and active funds to reach a middle ground. For example, by combining indexed and active components in a portfolio, a financial adviser may aim to meet a client's tolerance for tracking error risk while allowing potential for above-average returns from active managers seeking to outperform the market.
Alpha
An investment manager's return relative to the return of a benchmark.
Annual turnover
The percentage by value of stocks in a portfolio that are sold and replaced with new stocks each year. Index funds tend to have much lower turnover than active funds and are therefore likely to have fewer trading costs to pass on to investors and detract from performance.
Arbitrage
Profiting from differences in the prices quoted for a stock. Arbitrageurs simultaneously purchase and sell the same stock, usually on different exchanges or market places. In the case of iShares funds, market participants use arbitrage to make a profit by buying and selling iShares funds and their underlying stocks in the primary and secondary markets for iShares funds. This benefits all investors in the iShares secondary market - whether institutions or individuals - by helping to keep the market price of iShares funds close to the value of their underlying stocks.
Ask price, offer price
The lowest price sellers are willing to accept for a security.
Related terms: bid price, spread.
Asset allocation
The process of spreading an investment among a variety of asset classes such as stocks, bonds, property, and cash.