Passive Investing Glossary: Understand The Terminology & Definitions

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Confused about some of the terms we use on this site around passive investing? This page is for you!

Passive Investing: A strategy that aims to replicate the performance of a specific market index rather than trying to outperform it.

A

Active Investing: A strategy where investors aim to outperform the market by actively selecting and managing individual securities or making frequent trades based on market analysis and forecasting.

Asset Allocation: The process of dividing an investment portfolio among different asset classes, such as stocks, bonds, and cash, to achieve a desired risk and return profile. Passive investors may use passive allocation strategies based on predetermined asset class weights.

Asset Class: A category of investments with similar characteristics and behaviors, such as stocks, bonds, real estate, or commodities. Passive investors typically allocate their portfolios across different asset classes.

B

Beta: A measure of an investment’s sensitivity to changes in the overall market. Beta helps passive investors assess the volatility and systematic risk of a security or portfolio relative to a benchmark.

Bid-Ask Spread: The difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask) for a security. It represents the cost of executing a trade.

Broad Market Index: An index that represents a wide range of stocks or securities across various sectors or industries. Examples include the Wilshire 5000 Total Market Index or the Russell 3000 Index.

Buy and Hold Strategy: A long-term investment approach where investors buy securities and hold them for an extended period, regardless of short-term market fluctuations. It is commonly associated with passive investing.

Buy-and-Hold Investor: An investor who follows a long-term investment approach, typically associated with passive investing, by buying securities and holding them for an extended period, regardless of short-term market fluctuations.

Capitalization Weighting: A method used to determine the weight of individual securities in an index based on their market capitalization (total market value). Larger companies have a greater impact on the index’s performance.

C

Cash Drag: The negative impact on a fund’s performance caused by holding cash or cash equivalents instead of fully investing in the underlying securities. It can arise from inflows, outflows, or when the fund’s composition deviates from the index.

Commodity ETF: An exchange-traded fund that provides exposure to commodities such as gold, oil, natural gas, or agricultural products. Commodity ETFs allow passive investors to participate in commodity price movements without directly trading futures contracts.

Compound Interest: The concept of earning interest or returns not only on the initial investment but also on previously earned interest or returns. It allows investments to grow exponentially over time.

Core Bond Holdings: The fixed income portion of a portfolio that focuses on high-quality, investment-grade bonds. Passive investors often include core bond holdings for stability and income generation.

Core Holdings: The main and foundational investments in a portfolio. Passive investors often focus on core holdings, such as broad market index funds or ETFs, for long-term market exposure.

Core-Satellite Approach: An investment strategy that combines a passive “core” portfolio consisting of broad market index funds or ETFs with smaller “satellite” positions in specific sectors, themes, or active strategies. The core provides broad market exposure, while satellites allow for targeted bets.

Currency Hedging: A strategy used to mitigate the impact of currency fluctuations on international investments. Passive investors can choose currency-hedged ETFs or index funds to reduce the currency risk in their portfolios.

D

Defensive Stocks: Stocks that tend to perform relatively well during economic downturns or periods of market volatility. Passive investors may allocate a portion of their portfolio to defensive stocks for added stability.

Distribution Yield: The annual income generated by an investment, such as a dividend or interest payment, expressed as a percentage of the investment’s current price. Distribution yield is an important consideration for income-focused passive investors.

Diversification: Spreading investments across different asset classes, industries, or regions to reduce risk. Passive investing often achieves diversification by holding a broad market index.

Dividend Aristocrats: A group of stocks that have a history of consistently increasing their dividends for a certain number of years. Dividend Aristocrats are often included in dividend-focused passive investing strategies.

Dividend Yield: A financial ratio that represents the annual dividend payment of a stock relative to its current price. Dividend yield is a key consideration for passive investors seeking income-oriented investments.

Dividend: A portion of a company’s profits distributed to its shareholders on a per-share basis. Dividends can be an income component for passive investors, especially when investing in dividend-focused ETFs or index funds.

Dollar-Cost Averaging: An investment strategy where an investor regularly invests a fixed amount of money at regular intervals, regardless of market conditions. It allows for buying more shares when prices are low and fewer shares when prices are high.

Dollar-Weighted Return: A measure of the average compound rate of return experienced by investors in a fund, taking into account the timing and size of their contributions or withdrawals. Dollar-weighted return reflects the actual investment experience of investors in a fund.

Duration: A measure of a bond’s sensitivity to changes in interest rates. Duration helps passive investors assess the potential impact of interest rate fluctuations on their bond holdings.

E

ESG Investing: An investment approach that considers environmental, social, and governance factors when selecting securities. Passive investors can choose ESG-focused ETFs or index funds that align with their sustainability goals.

ETF (Exchange-Traded Fund): A type of investment fund that trades on stock exchanges, representing a basket of assets such as stocks, bonds, or commodities. ETFs are designed to track the performance of a specific index or sector.

Exchange-Traded Commodity (ETC): Similar to commodity ETFs, ETCs are exchange-traded products that provide exposure to physical commodities. ETCs may hold the physical commodity or use derivatives to track the commodity’s price.

Exchange-Traded Note (ETN): A type of unsecured debt security issued by financial institutions, often designed to track the performance of an index. ETNs differ from ETFs in that they do not own the underlying assets but rather promise to pay returns based on the index performance.

Expense Ratio: The annual fee charged by a mutual fund or ETF to cover operating expenses and management fees. It is expressed as a percentage of the fund’s total assets and represents the cost of investing in the fund.

F

Factor Investing: An investment approach that seeks to systematically capture specific factors or characteristics associated with higher returns, such as value, size, profitability, or low volatility. Passive factor-based ETFs or index funds focus on these factors in their portfolio construction.

H

High-Yield Bond: A bond with a lower credit rating and higher risk of default compared to investment-grade bonds. Passive investors may include high-yield bond indexes or ETFs in their portfolio to seek higher yield but with increased credit risk.

I

Inception Date: The date when a mutual fund or ETF was first made available for investment. It indicates the start of the fund’s performance history.

Index Fund: A type of mutual fund or exchange-traded fund (ETF) that aims to track the performance of a specific market index, such as the S&P 500. It holds a diversified portfolio of securities that mirrors the index it tracks.

Index Provider: An organization that designs, calculates, and maintains indexes. Examples include S&P Dow Jones Indices, MSCI Inc., and FTSE Russell.

Index Reconstitution: The periodic process of updating the composition of an index to reflect changes in the market. Index reconstitution may involve adding or removing securities based on specific criteria, such as market capitalization or sector representation.

Index Weighting Methodology: The approach used to determine the weight of individual securities in an index. Common indexing methodologies include market capitalization weighting, equal weighting, or factor-based weighting.

Inflation: The rate at which the general level of prices for goods and services is rising and, as a result, the purchasing power of currency is falling. Passive investors consider the impact of inflation on their investment returns over the long term.

Investment Horizon: The length of time an investor expects to hold their investments before needing the funds. Passive investing is typically considered a long-term strategy that aligns with longer investment horizons.

L

Liquidity: The ease with which an asset can be bought or sold in the market without significantly impacting its price. Passive investors often prefer highly liquid investments to ensure efficient trading.

Long-Term Capital Gain: Profit generated from the sale of an investment held for more than one year. Long-term capital gains are often taxed at lower rates than short-term gains, providing potential tax advantages for passive investors.

M

Market Capitalization: The total market value of a company’s outstanding shares of stock, calculated by multiplying the current stock price by the number of shares outstanding. It is used to determine the weight of a company in market-cap-weighted indexes.

Market Efficiency Hypothesis: The theory that financial markets are efficient and reflect all relevant information, making it difficult to consistently outperform the market through active investing. Passive investing aligns with the belief in market efficiency.

Market Efficiency: The degree to which prices in the market reflect all available information. Passive investing assumes that markets are generally efficient, making it difficult to consistently outperform them through active strategies.

Market Index: A benchmark that represents a specific segment of the financial market, such as the S&P 500 or the Dow Jones Industrial Average. It measures the performance of a group of securities or the overall market.

Market Order: A type of order to buy or sell a security at the prevailing market price. It executes the trade as quickly as possible, regardless of the specific price obtained.

Market Sentiment: The overall attitude or feeling of investors toward the market or a specific asset class. Passive investors may monitor market sentiment as an indicator of potential market movements.

Mean Reversion: The tendency of investment returns or prices to move back to their long-term average over time. Passive investors may be aware of mean reversion when considering the potential future performance of an investment.

Monte Carlo Simulation: A statistical technique used to model the probability of various outcomes in investing. Monte Carlo simulations can help passive investors assess the potential risk and return characteristics of their portfolios.

N

Net Asset Value (NAV): The per-share value of a mutual fund or ETF, calculated by dividing the total value of the fund’s assets minus liabilities by the number of shares outstanding. It is typically calculated at the end of each trading day.

P

Passive Allocation: The process of allocating assets in a portfolio based on predetermined asset classes or market indexes. Passive allocation aims to maintain a consistent asset mix without making frequent changes based on market conditions.

Passive Foreign Exchange Investing: An investment strategy that seeks to replicate the performance of a foreign currency or foreign currency basket through passive investment vehicles. This approach allows investors to gain exposure to foreign exchange movements without actively trading currencies.

Passive Foreign Exchange Risk: The risk of currency fluctuations impacting the value of international investments. Passive investors should consider the potential impact of foreign exchange risk when investing in global or international funds.

Passive Foreign Investment Company (PFIC): A non-U.S. corporation that primarily generates passive income or holds passive assets. PFICs have unique tax implications for U.S. investors.

Passive Income: Income generated from investments or assets without actively working or providing direct effort. Passive investing aims to generate passive income through appreciation and income distributions.

Principal: The original amount of money invested in a financial instrument, such as a bond or stock. Passive investors consider the preservation of principal while aiming for long-term growth or income.

Prospectus: A legal document that provides detailed information about a mutual fund or ETF, including its investment objectives, fees, risks, and past performance. It is important for investors to review the prospectus before investing.

R

Real Estate Investment Trust (REIT): A company that owns, operates, or finances income-generating real estate properties. Passive investors can gain exposure to the real estate market through REIT-focused index funds or ETFs.

Rebalancing: The process of adjusting the asset allocation of a portfolio to maintain the desired target allocation. In passive investing, rebalancing typically involves buying or selling assets to align with the index being tracked.

Rebalancing: The process of realigning a portfolio back to its target asset allocation by buying or selling assets. Passive investors may periodically rebalance their portfolios to maintain desired risk levels and investment objectives.

Risk Capacity: The level of risk an investor can afford to take on based on their financial situation, goals, and time horizon. Passive investors should assess their risk capacity to align their investment strategy with their risk tolerance.

Risk Parity: An investment approach that aims to distribute risk equally across different asset classes in a portfolio. Passive risk parity strategies allocate more to less volatile assets and less to more volatile assets.

Risk Tolerance: An investor’s willingness and ability to withstand fluctuations in the value of their investments. Passive investing is often associated with a more conservative risk tolerance, as it aims to capture broad market returns over the long term.

Risk-Adjusted Return: A measure that assesses an investment’s return in relation to its risk. Passive investors consider risk-adjusted return metrics, such as the Sharpe ratio or the information ratio, to evaluate investment performance.

Risk-Free Rate: The theoretical rate of return on an investment with zero risk, often represented by government bonds. The risk-free rate serves as a benchmark for evaluating investment returns and measuring risk premiums.

S

Sampling: A technique used by index funds or ETFs to replicate the performance of an index by holding a subset of the index’s securities rather than all of them. It is commonly used for indexes with a large number of constituents.

Sector Index: An index that represents a specific sector of the economy, such as technology, healthcare, or energy. Sector-specific ETFs or index funds allow passive investors to target specific sectors.

Securities Act of 1933: A U.S. federal law that regulates the issuance and sale of securities to protect investors from fraud. The Securities Act requires companies to provide detailed information to investors before offering securities to the public.

Securities and Exchange Commission (SEC): A regulatory body in the United States responsible for enforcing securities laws and protecting investors. The SEC oversees the registration and regulation of mutual funds, ETFs, and other investment vehicles.

Securities Exchange Act of 1934: A U.S. federal law that governs the secondary trading of securities, including stocks and bonds, on the organized exchanges and over-the-counter markets. The Securities Exchange Act establishes rules for disclosure, registration, and market regulation.

Securities Lending: A practice in which a mutual fund or ETF lends its securities to other market participants, typically in exchange for collateral. It can generate additional income for the fund, potentially reducing expenses or improving returns for investors.

Short Selling: A trading strategy where an investor borrows shares of a security and sells them, expecting the price to decline. Short selling is not typically used in passive investing, which aims to capture market returns rather than bet against them.

Smart Beta: A strategy that combines elements of passive investing and active factor-based investing. Smart beta funds seek to deliver returns that are different from traditional market-cap-weighted indexes by using alternative weighting schemes based on factors like value, momentum, or low volatility.

Style Analysis: A technique used to analyze the investment style characteristics of a portfolio or fund. Style analysis helps passive investors understand the underlying investment factors driving performance.

Style Box: A visual representation of an investment fund’s investment style, typically depicted as a grid with size (large-cap to small-cap) along one axis and value-growth along the other axis. Style boxes help investors understand a fund’s investment characteristics.

Style Drift: When a fund’s investment style deviates from its stated objective or intended investment strategy. Passive investors may monitor for style drift to ensure that the fund maintains alignment with its intended index or investment approach.

Style Driven Investing: An investment approach where portfolios are constructed based on specific investment styles, such as growth, value, or quality. Passive style-driven ETFs or index funds provide exposure to specific investment styles.

Style Index: An index that categorizes stocks based on investment styles, such as growth or value. Passive investors can choose style-specific ETFs or index funds to align with their investment preferences.

Style Risk: The risk associated with investing in a specific investment style or factor. Passive investors should be aware of the potential for style risk when allocating their portfolio to style-specific index funds or ETFs.

Style Rotation: A strategy that involves shifting investments between different investment styles based on market conditions. Passive investors may employ style rotation by periodically rebalancing their portfolio to maintain desired style exposures.

Synthetic ETF: An exchange-traded fund that uses derivatives, such as swaps, to replicate the performance of an underlying index. Synthetic ETFs are designed to track the index without holding all of its constituent securities.

Systematic Risk: Also known as market risk, it refers to the risk that affects an entire market or multiple assets within it. Passive investors are exposed to systematic risks inherent in the market they are tracking.

T

Tactical Asset Allocation: A strategy that involves adjusting the asset allocation of a portfolio based on short-term market outlook or anticipated trends. Tactical asset allocation differs from passive investing, as it incorporates active decision-making.

Target Date Fund: A mutual fund or ETF designed for retirement savings that automatically adjusts its asset allocation based on a specific target retirement date. Target date funds are often used by passive investors as a “set it and forget it” option.

Tax Efficiency: The ability of an investment to minimize the tax impact on investment returns. Passive investment vehicles, such as index funds, are generally known for their tax efficiency compared to actively managed funds.

Tax-Advantaged Accounts: Investment accounts that offer tax benefits, such as Individual Retirement Accounts (IRAs) or 401(k) plans. Passive investors may utilize tax-advantaged accounts to optimize tax efficiency and maximize long-term returns.

Tax-Exempt Bond: A bond issued by a government entity or municipality that is exempt from federal income taxes or, in some cases, state and local taxes. Passive investors may include tax-exempt bond indexes or ETFs in their portfolio for tax efficiency.

Tax-Loss Harvesting: A tax strategy where investors sell securities that have experienced a capital loss to offset capital gains and potentially reduce their tax liability. Passive investors may employ tax-loss harvesting in taxable investment accounts.

Total Bond Market Index: An index that represents the performance of a broad universe of bonds, including government bonds, corporate bonds, and municipal bonds. Passive investors may include total bond market indexes for exposure to the fixed income market.

Total Expense Ratio (TER): The total annual cost of owning a mutual fund or ETF, expressed as a percentage of the fund’s total assets. The TER includes the management fee, operating expenses, and other costs associated with fund management.

Total International Stock Index: An index that represents the performance of stocks listed in international markets, excluding the domestic market of the index’s country. Passive investors may include total international stock indexes in their portfolio for global diversification.

Total Return: The overall return on an investment, including capital appreciation (increase in value) and any income generated, such as dividends or interest.

Total Stock Market Index: An index that represents the performance of a broad and comprehensive universe of stocks, covering large-cap, mid-cap, and small-cap stocks. Examples include the CRSP US Total Market Index or the Dow Jones U.S. Total Stock Market Index.

Tracking Basket: A portfolio of securities held by an ETF or index fund that aims to closely track the performance of its underlying index. The tracking basket may include a representative sample of securities or use optimization techniques.

Tracking Difference: The discrepancy between the performance of an index fund or ETF and its underlying index. It can be influenced by factors such as expenses, cash drag, and sampling techniques.

Tracking Error: The extent to which the performance of an index fund or ETF deviates from the performance of its underlying index. It measures the effectiveness of the fund in replicating the index.

Tracking Index: The specific market index that an index fund or ETF aims to replicate. The choice of tracking index determines the securities and weightings within the fund.

Tracking Risk: The risk that an index fund or ETF may not perfectly replicate the performance of its underlying index. Factors such as tracking error, fees, and liquidity can contribute to tracking risk.

Y

Yield Curve: A graphical representation of the relationship between the interest rates and the time to maturity for a set of fixed-income securities. The yield curve helps passive investors analyze the term structure of interest rates.

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