The intimidation factor of choosing an investment vehicle can be one of the reasons why potential investors might feel more comfortable keeping their nest egg in their mattress.
Not only does it seem as though the financial world speaks an entirely different language from the rest of us, but we also know that making a poor choice could be potentially very costly.
However, even the greenest of investors in mutual funds have the same opportunities to understand their options and make good decisions as everyone else—thanks to the Securities and Exchange Commission’s regulations on prospectuses and annual reports.
A prospectus is a document that provides investors with information about the investments that make up the mutual fund, as well as other details of the company’s business. All companies that file with the SEC are required to provide this information to investors and potential investors, and these documents give all investors the necessary knowledge to make good choices.
But a prospectus (and the Statement of Additional Information or SAI, which will often accompany the prospectus), can “read like stereo instructions” in Greek. If you are looking to invest in a mutual fund, here is what you need to know about reading the important parts of the prospectus without tearing out your hair:
Finding a Mutual Fund Prospectus
Before you can read a prospectus, you will need to know where to find them. This has gotten somewhat easier in the age of the Internet. It used to be that you would have to either contact the mutual fund company directly or ask your financial adviser to get you a copy of the prospectuses you were interested in.
These days, you can obtain prospectuses online—either directly from the company’s website (generally found within the Investor Relations section) or on the SEC’s Electronic Data Gathering, Analysis and Retrieval System (EDGAR) site. The EDGAR website allows you to search for specific companies’ prospectuses and other filings.
You will encounter two types of prospectuses: statutory and summary. The statutory prospectus is the long-form, traditional prospectus that most investors are familiar with. The summary prospectus, on the other hand, provides key information on the fund in three to four pages. While both types offer important information, you will be able to get more detailed information from the statutory prospectus.
It’s always a good idea to also request or download the SAI, as it can provide additional insight into your investment. Here’s an example of page one of a summary prospectus:
The first stop in reading your prospectus is the information on the Investment Strategy. This is the first thing you want to check on because if your personal investment strategies and objectives do not match those listed, it’s time to move on to the next prospectus. Since every prospectus can be written a little differently, you may find this listed in the table of contents as Risk/Return, Investment Objectives, Primary Strategies, or Primary Risks.
Under this section, you will find a description of how investors’ money will be allocated and what the risks are in buying the fund. If you are new to investing, the asset allocation descriptions and various risks may seem to go over your head. Not to worry. The site Investopedia offers an excellent dictionary of financial terms, and you should also feel free to call the fund company and ask for clarification. Never invest in something if you do not fully understand what is being done with your money.
Looking at Returns
If the mutual fund whose prospectus you are reading seems to line up with your objectives and your risk tolerance, it’s time to turn to the section on investment returns. For most funds, this will be the easiest section of the prospectus to understand.
You will often see two tables: one that compares the returns of fund in question to the 1-, 5-, and 10-year returns of index funds (like the S&P 500), and one that shows the annual or quarterly returns for the past 10 or so years. The index comparison is important information to have, as it will give you an idea of what to expect long-term, particularly in relation to the index funds.
However, you will also want to look at the yearly/quarterly returns for the fund, as that will give you a better idea of the volatility of the fund. Kiplinger’s recommends looking at the fund’s worst year or quarter because only you know if you can live with a result like that if it happens again.
Fees and Expenses
This is probably one of the most difficult sections to analyze since it is in the fund’s best interest for you to not completely understand what fees are in store for you.
First, it’s important to note that we at PT Money do not recommend buying loaded funds. You can find no-load mutual funds that do not charge an upfront fee, so there is no reason to waste money on a loaded fund.
That being said, even no-load mutual funds still have fund expenses, which are paid out of the funds’ assets. You can find the information on these expenses in a section generally titled Fees and Expenses. Look for the Net Annual Fund Operating Expenses, and you will find the expenses expressed as a percentage.
For example, if the listed percentage is 0.97%, you will pay $9.70 for every $1,000 you have invested in the fund. But remember, you will pay those operating expenses whether you earn or lose money.
Of course, this is not the end of possible fees and expenses. In addition, check to see if there is a section listed as Investment Adviser and Management Expenses. This will let you know if there is a performance bonus to the investment manager in years when they outperform their benchmark. That bonus will come from a small percentage of your investment, meaning your net annual operating expenses might be higher than what is listed.
Finally, the turnover cost is something that many investors forget to include in their fee calculations. Higher turnover—that is, when the manager buys and sells securities more often—can mean additional costs and additional taxes if your fund is in a taxable account. Neal Frankle wrote about the effect of high turnover on mutual fund fees for Get Rich Slowly :
“John Bogle of Vanguard fame has spoken about turnover many times. According to his estimate, a 100% turnover adds another full 1% to the cost of a fund. So [if for example,] the turnover was 32% last year… we [would] have to add another 0.32% to the total costs.”
While all fees must be disclosed to the investor, it can be very easy to underestimate the fees you will be facing since it will take some diligence to find all of these fee disclosures. This is a situation wherein it really pays to do your homework.
The Bottom Line
Reading a prospectus is nothing like enjoying the latest Dan Brown novel. It’s generally not something you would choose to read on the beach—or anywhere. But taking the time to read through several prospectuses and making certain that you understand exactly what is in store for investors is an excellent investment in yourself. You’ll feel better educated about your options and will not be in a position to be paralyzed by indecision, or be the victim of a hard sell.
That’s certainly worth an afternoon of your time.
Do you have any suggestions for reading a prospectus? What has worked for you in making sure you understand your investment?