If you invest in mutual funds, including index funds, one of the key things you need to know involves a document called the mutual fund prospectus. The Securities and Exchange Commission (SEC) requires firms to file this legal document so that anyone who may wish to invest in the fund has access.
If you plan to invest in a mutual fund, it is crucial to access and review the prospectus. It contains a massive amount of information that you can't get elsewhere.
The firm that manages your mutual fund will use a single approach or set of rules to invest your money. Some funds follow a value investing strategy, while some go for growth stocks. Others may use more risky strategies that involve stock options. These days, it is fairly common to use a strategy based on mimicking an index such as the S&P 500.
Investor Paid Expenses
The prospectus includes a breakdown of the types of expenses that the fund shareholders paid over the past few years. These fees include management fees to cover the operating cost of hiring and working with advisors, analysts, and managers. They also include 12b-1 fees that help cover the cost to market and to pay 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 or back-end.
Front-end loads are charged when shares are bought. Back-end loads are charged when shares are 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 during the holding period. Sales loads go to pay brokers.
Redemption fees are also charged when a fund is sold. This type of fee goes straight 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 expense per year as a percent you will be charged if you invest.
Performance and Risk Disclosures
The long-term performance disclosure compares how well a mutual fund performs when compared to a benchmark such as the Dow Jones Industrial Average. The mutual fund prospectus may explain why a certain benchmark is the best method to compare and assess.
When you invest in any given mutual fund, you have no choice but to face some major risks. The prospectus will include these risks so that you have fair warning. For example, a global or international mutual fund prospectus will go into extra detail to explain currency risks, the chance that a company might restrict capital, or the dangers of war. It may also include a number of other factors that are less relevant to a strictly domestic fund.
If the fund employs leverage, it will be explained where and when they do this. The prospectus will tell if the mutual fund lends its own securities out to others, such as short sellers, in exchange for income.
Leverage is when a fund borrows money in some form in order to increase returns.
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 concept as to the tax efficiency of the fund. Longer holding times tend to result in deferred tax liabilities.
Directors and Management
The names of the directors or trustees who represent the mutual fund shareholders will be listed. Along with the names, you will be given the range of how much each person invests in the fund (such as $10,0001 to $50,000 or $100,000+). You will also be able to see how much each person earns for their service. This includes the amount the directors are paid, as well as the control persons and the principal owners of the fund. This will include the firm's holding securities on behalf of the actual investors in "street names."
You can use these details about the managers of the mutual fund assets to help you assess whether or not you think they have the knowledge and credentials to handle your money.
The range of money invested by the people who are in charge of making major strategic moves will be disclosed. This includes the portfolio manager or members of the investment committee. It will show you if they have money in the fund itself. This factor alone can help you decide how much they have at stake, and whether they are sufficiently exposed to the risks of their choices. 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 Can You Find a Mutual Fund Prospectus?
Mutual fund companies are required by law to provide you with a prospectus before you invest. Almost all fund companies now post their prospectus online for public view as a free download. It sounds overly simple, but you can either search for "[Fund Name] prospectus" in a search engine or find the official mutual fund website and look around. It's sure to be listed 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 know what you're getting into if you choose to invest.
Most brokers will also be able to provide a copy. In recent years, many of the largest online stock brokers have included a link to the mutual fund prospectus on the search results that are displayed if you search the ticker symbol on the broker's site.
Once you read a few dozen of these, you should start to get a feel for what is normal and what isn't. This is a good habit to get into because, if you are wise, it can aid you in building a better portfolio for your own needs.