Understanding the Mutual Fund Prospectus
If you invest in mutual funds, including index funds, one of the most important things you need to know involves a document called the mutual fund prospectus. The Securities and Exchange Commission (SEC) requires funds to file this legal document and make it available to potential investors. It is extremely important to you because it contains a tremendous amount of information that you can't get elsewhere.
Mutual Fund Investment Strategy
The mutual fund management company will use to invest your money. Some funds follow a value investing strategy, some go for growth stocks, while still others may use risky strategies involving stock options. These days, a popular mutual fund strategy is based on mimicking an index such as the S&P 500.
Investor Paid Expenses
The prospectus includes a breakdown of the historical expenses paid by the mutual fund shareholders over the past few years. These fees include management fees to cover the operating cost of employing investment advisors, analyst, and managers and 12b-1 fees that help cover the fee to market and compensate securities professionals.
The sales load will also be defined. Loads are the commissions charged when an investor buys or sells shares in the fund. Loads can be front-end—charged when bought, back-end—charged when sold. Some funds may be classified as no-load funds. While no-load funds do not charge fees on entry or exit, they will charge fees throughout the holding period. Sales loads go to pay brokers.
Redemption fees are also charged when a fund is sold. This fee goes directly to the fund management and is used to offset the cost to process the redemption.
Other fees include account fees, purchase fees, and annual operation fees. The prospectus will have a fee table that will show the total annual operating expense charged to the investor as a percentage.
Performance and Risk Disclosures
Long-term performance disclosure comparing the mutual fund's performance to a benchmark such as the Dow Jones Industrial Average. The mutual fund prospectus may explain why a certain benchmark is the most appropriate comparison.
Major risks you are likely to face when investing in a particular mutual fund will be included in the prospectus. For example, a global or international mutual fund prospectus is probably going to spend time explaining currency risks, the possibility of companies implementing capital restrictions, the dangers of war, and other considerations that are less relevant (under most circumstances) to a purely domestic mutual fund.
If the fund employs leverage it will be explained where and when they do this. Leverage is the use of borrowing to increase returns. The prospectus will tell if the mutual fund lends its own securities out to others, such as short sellers, in exchange for income.
The portfolio turnover rate will also be shown. Turnover means the changes to the holdings in the fund's portfolio. This information can give you some idea as to the tax-efficiency of the fund (longer holding periods tend to result in deferred tax liabilities).
Directors and Management
Names of the directors or trustees who represent the mutual fund shareholders, including the range of their investment in the fund (e.g., $10,0001 to $50,000 or $100,000+) are provided. The amount the directors are paid for their service and the control persons and principal owners of the fund will be listed. This will include the institutions holding securities on behalf of the actual investors in "street names"
Information about the managers of the mutual fund assets to help you determine whether or not you think they have the credentials, experience, and temperament to handle your money
The range of investment the people making the decision about the fund's investment strategy is disclosed. This includes the portfolio manager or members of the investment committee and will show if they have money in the fund itself. So, you can decide whether they are sufficiently exposed to the risks of their decisions. An example may say, "John Smith, the Chief Investment Officer, has $100,001 to $500,000 of his own money invested in the ABC mutual fund, and $500,001 to $1,000,000 of his own money invested in the XYZ mutual fund."
Where to Find a Mutual Fund Prospectus
Mutual fund companies are required by law to provide you with a prospectus before you invest. Virtually all fund companies now make their prospectus available online as a free download. It sounds overly simplistic, but you can either search for "[Fund Name] prospectus" in your favorite search engine or find the official mutual fund website and look around because it's sure to be listed somewhere nearby. You may also come across a summary prospectus which is a shorter version of the full prospectus.
Fund managers want you to read this information because they want you to understand the investment.
Most brokers will also be able to provide a copy of the prospectus. In recent years, many of the largest online stock brokers have included a link to the mutual fund prospectus on the research results that are displayed if you search the ticker symbol on the broker's site.
Once you read a few dozen mutual fund prospectuses, you should start to recognize what is normal and what isn't. This is important because, if you are wise, it can aid you in constructing a better portfolio for your own needs.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.