How to Read a Mutual Fund Prospectus
Raise your hand if you read the fund prospectuses that your mutual fund companies send you in the mail!
I always ask my workshop attendees to do this and am never surprised when just a couple of hands go up. The reasons people don't even open the covers of these fascinating documents are simple: They can be intimidating and look pretty boring. Fortunately, neither of those assumptions are true.
Prospectuses only appear complicated and scary because the type is small and they seem to have a lot of numbers in them. In reality--just as with almost any other type of financial document--once you've read a couple, you see that they follow a standard format and can be scanned pretty quickly for the information you need.
I cannot emphasize enough that this process is absolutely critical. More than 90% of mutual funds in the marketplace underperform the S&P 500. You don't want to buy a fund that has a long-term history of lackluster returns, therefore, becoming comfortable with a prospectus is essential. It truly can make a difference between buying funds with so-so returns, or those that will perfectly meet your long-term investment needs.
So just give me a few minutes of your time and I'll tell you how to quickly read these reports and go right to the nuggets of information you need to determine if the fund is the right one for you.
But first let me say this: When you buy shares in a mutual fund--by law--the fund must give you a prospectus, but you should read it before you put your first dollar into the fund.
Now, take out your prospectus and get ready to learn the tricks of the trade:
Date of Issue: This should be right on the front cover. If the date is more than one year old, don't bother with the prospectus; just get a new one.
Description of Fund, or Objective Statement: At the beginning, this section tells you the objectives and goals of the fund, its strategies for investment, and its major risks. This section should disclose how much the fund is going to make from the task of managing your money, the returns it has generally delivered up to now and the types of investments it usually buys to achieve these results.
This first glance will begin to give you the information to decide if the fund's objectives align with yours. Make sure you keep your personal risk tolerance in mind. If you are extremely cautious, a technology fund with high volatility is probably not going to help you sleep at night. Instead, a balanced fund may be more to your liking.
Performance: While performance should never be the only reason you invest in a fund, it is extremely important, because after all, the goal of investing is to make money! Just keep in mind, as you peruse the fund's returns, performance over a one-year period is pretty meaningless. Any investment can have an excellent or a terrible year. To effectively gauge a fund's real performance, it is essential that you look at its returns over a period of time.
Fortunately, the prospectus makes this easy to do. The Securities and Exchange Commission (SEC) requires that a fund disclose its 1-, 3-, 5- and 10-year performance numbers (if the fund has been in existence that long). And since Feb. 15, 2002, the SEC has also mandated that all funds must explicitly state their after-tax returns—a very good thing, as many investors neglect to take this all-important factor into consideration!
This section should include a risk/return table, listing the percentage return before taxes, percentage return after taxes on the fund's distributions and the percentage return after taxes on distributions and sales of funds.
Now, you may ask, what do you do with these numbers once you get them? First, compare your fund's return with the performance of its index. A general rule of thumb is if the fund underperforms the index by more than 5%, it should probably not be at the top of your buying list.
After that exercise, it's time to compare the fund's returns with other similar funds that you are considering buying. Again, if the fund has outperformed your other proposed selections, over time, it may be worth pursuing. Remember, the long-term is what counts, so make sure any fund you are considering purchasing is showing good performance over a multi-year period.
But before you make the purchase decision, there's one more important factor you need to take into consideration...
Fees and Expenses: Mutual funds come with various costs and you will want to review and compare all of them to your fund's returns, its index's average expenses, and the costs of the other, comparable funds on your radar screen. Here are the expenses and fees you will most commonly see:
A management fee is charged by all funds for the management of the fund, as well as the expenses incurred from buying and selling investments. It can run from .5%-2.0%, or even more, and is called the expense ratio, or the percentage of total fund assets used to pay for expenses.
The 12b-1 fee is generally for advertising and marketing costs and usually ranges between .25%-.75%. Not every fund has a 12b-1 fee.
Loads come in two flavors. The first is a front-load, levied upon purchase of the fund and sometimes also on the reinvestment of dividends, interest and capital gains. It usually ranges between 2%-8.5%.
A back-end load, also sometimes called a deferred sales charge, is paid at the time of redemption of the fund (when you sell it). It is often larger than the front-end load and sometimes declines incrementally and then disappears altogether over a 5-8 year holding period. This fee is levied to discourage investors from jumping into and out of funds.
Just as with fund returns, you will want to review these expenses over the long-term, not just a 1-year period, comparing them to the fund's index as well as other funds you are considering.
When comparing expenses and fees, generally, the lower the better, but make sure you also review the fund's returns. Subtract the fees from the performance numbers as your first step when comparing funds. Just because a fund is no-load doesn't mean it is the best fund for you. Often, you will find that some of the no-load, or low-expense funds, post some of the worst returns. It is imperative that you take both expenses and performance into account before making your fund purchases.
How to Purchase and Redeem Shares: This section just tells you how to buy and sell shares in the fund.
File number: This is on the back page of the prospectus and begins with 811-. It is used to catalog all the fund's filings in the SEC's EDGAR database.
There you have it—the quick and easy way to read a mutual fund prospectus! You no longer have an excuse to just pile them in a corner and now have the tools needed to determine which funds are best for your goals and strategies.
Happy Investing!
About the Author
Nancy Zambell, Contributing Editor to BrokerAdviser.com's Financially Fit, has enjoyed a diversified career in the financial services industry.
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