Do I Need to Look at the Fund Prospectus?
It might not be fun, but it's a must.
Question: I'll confess that I often skim mutual fund prospectuses, if I read them at all. What are the key areas to which I should devote my attention?
Answer: Granted, prospectuses are not the most riveting read. But they're there to help investors make informed decisions, and they contain all the make-or-break pieces of information that you'd want to know before you invest in a fund.
Fund prospectuses are easily accessible--either from the fund company's website or by calling or sending an e-mail to the fund company. You can also obtain prospectuses by searching this SEC database by fund company. On Morningstar.com, the Filings section on the quote page for mutual funds also provides links to the most recent prospectus for a given fund as well as its most recent annual and semiannual reports and statement of additional information.
Below, we've outlined the most critical parts of a fund's prospectus. These are the sections you should definitely home in on before investing in a fund.
Here, you'll find a statement of the fund's goals, which fund companies cannot change without the majority consent of shareholders. Common investment objectives include capital appreciation, current income, or preservation of capital.
A fund's investment strategy section should clearly explain how the fund plans to meet its stated investment objective. This section will address asset allocation, as well as types of investments the fund will use, investments the fund may use, and any investment restrictions. (Anything not detailed in the prospectus regarding investment restrictions can be found in the Investment Policies and Restrictions section of the fund's Statement of Additional Information).
Unfortunately for would-be buyers, this section is often written very broadly to give the manager the maximum possible leeway, whether he is likely to use it or not. For example, a plain-vanilla domestic-stock fund's strategy section may spell out that the manager can buy futures or invest all of the fund's assets in foreign stocks, even if the manager has never done so in the past.
That said, reading about the fund's specific strategy will help distinguish among funds with the same investment objectives, which tend to be quite broad and generic. For example, two mid-cap funds may both strive to deliver "long-term growth of capital" but will subscribe to different investment strategies to achieve that goal.
Instances in which the fund's trustees may have the authority to change the fund's objective or strategy without holding a shareholder vote will also be detailed in the prospectus (sometimes not so conspicuously). But this comes with the stipulation that the fund must notify its shareholders in writing before effecting any change.
This section of the prospectus should clearly outline the potential risks that come with investing in the fund. It's important that you understand these risks before you invest any money with the fund, so if there's anything that you don't understand in this section, call the fund company for clarification. As with the investment strategy section, the risk section is often written very broadly; Morningstar's Fund Analyst Reports can provide additional color on what a fund's true risk factors are apt to be.
Fees and Expenses
This section is worth a slow and careful review because fees are such a big determinant of a fund's relative performance. Funds may levy sales charges, or loads, which include front-end loads (a charge when you buy into the fund) or back-end loads (also known as redemption fees or deferred sales charges) that kick in when you sell shares of the fund. (Redemption fees are designed to discourage investors from trying to time the market by jumping in and out of the fund). Some fund companies may impose an exchange fee for investors who move money from one fund to another within the same fund family.
Right below sales charges, you'll find annual operating expenses, which have three components: the management fee, 12b-1 fee, and "other expenses," covering a hodgepodge of administrative costs. Together, these three expense components add up to equal the total annual operating expenses for the fund.
Investors are likely to find some revealing information in this section of the prospectus, including the fund's yearly turnover rate (funds with high turnover rates may rack up high trading and tax costs), expense ratios, total net assets, and income and capital gains distributions for each of the past five years. Keep an eye on the trends you see in these numbers. If the fund's total net assets have gone up substantially, the fund's expense ratio should be on the downtrend.
This section spells out how often--and when--the fund will distribute income and capital gains to its shareholders.
Excessive Trading Policy
This section details the steps the fund will take to limit excessive trading. For example, a fund may limit the number of so-called roundtrip transactions within a specified period, often 30 days.
It's true that past performance does not guarantee future performance. But it's still a good idea to take a look at the fund's long- and short-term historical performance--especially in relation to the fund's benchmark. If a fund has consistently trailed its benchmark, it may not be worth paying for active management.
You'll also be able to see some data about the return that investors in taxable accounts have earned, both if they had sold their shares and if they had continued to hold them.
You'll find information here about how long the fund manager has been behind the helm. This way, you can put the fund's performance in context. For example, you cannot attribute a fund's stellar five-year performance to the current manager if he has only been with the fund for two years. For a more accurate gauge of a fund manager's ability and talent, you may want to look into the prospectuses at his previous charges. A fund's statement of additional information will provide more details on the fund manager.
Potential Conflicts of Interest
Some funds make payments to broker-dealers and/or other financial intermediaries for selling shares. Fund companies don't all put this information in the same spot within the prospectus. Investors who are purchasing funds through a brokerage firm or another intermediary should seek out this information because brokers and salespersons might have a built-in incentive to recommend certain investments over others.
Statement of Additional Information
The SAI is an extension of the prospectus that expands on some of the matters described in the prospectus. But it's worthwhile to take a look at this document, too, because fund companies are legally required to provide this information along with the prospectus.
One potentially useful piece of information you will find in the SAI is how much the manager has invested in his fund. While it's not necessarily an indication of good performance, it's a plus when there's evidence that managers' incentives are aligned with those of the shareholders. Morningstar's Stewardship Grades rely heavily on a fund's statement of information to assess how shareholder-friendly a fund firm has been.