How to Read a Mutual Fund Prospectus
Mutual funds have two goals: to make themselves money and to make you money, usually in that order. The mutual fund prospectus gives you a chance to weigh a fund's greed against its performance so you can determine whether these guys are worth what they charge. It also gives you some fundamental parameters for comparing one fund with another.
Sure, a prospectus looks daunting. It might be simpler if there were just a single line at the top with a fill-in-the-blank structure. For example, "The ____ Fund will jack you up for about ____ percent of your assets every year in expenses while growing those assets by __ percent less than the S&P 500 in an average year by investing in ____."
After a little practice at reading these things, though, you should be able to fill in the blanks yourself since the prospectus actually does answer an investor's essential questions:
- How much is the fund going to make from managing your money.
- What kinds of returns has the fund delivered for investors in the past, and what does it generally invest in to achieve these results?
The very basics are usually outlined on the cover page, though to really get a feel for the fund, you should sink your teeth into a few key sections of the prospectus.
One of the major reasons that 90% of mutual funds underperform the S&P 500 index is not that the fund managers are dopes but that they charge a lot for investment advice that is literally little better than average. It's inherently more expensive to make active investment decisions than it is simply to follow a set investment menu, as the Vanguard index funds do. That's one reason that annual expenses at Vanguard's funds run around 0.31% (31 cents per $100) of assets versus 2% ($2 per $100) or more for many actively managed funds. Just to perform as well as the index fund, then, a given mutual fund might need to do 1.69% better.
Annual management fees are just one of the charges an investor finds on perusing the prospectus section devoted to Transaction and Fund Expenses. The transaction side tells you about the sales charge or "load" (what it will cost you to buy into the fund), the sales charge to reinvest distributions (what it will cost to reinvest the annual profits the fund distributes to you), the redemption fees (what it will cost you to sell your shares of the fund), and the exchange fee (what it will cost you to move money from one fund to another in the same family of funds). Not all funds charge these fees, but you need to be aware that some do.
The first item is the sales charge or "load" for buying into the fund. Not too long ago, mutual fund companies routinely charged you 8.5% of your initial investment just to let you in the door. Most of this amount went to pay a commission to the broker who signed you up. In the 1970s, some firms started offering no-load funds, which meant you didn't have to pay a sales charge upfront just to put your money to work. Given that no study has ever shown that load funds deliver better returns than no-load funds, Fools should assume that no-loads are the better way to go. Yet once you've dodged that bullet, you must take a closer look at the other ways the fund plans to make money from you since, after all, that's why they're in business.
One possibility is some kind of a back-end load, also known as a redemption fee, or deferred sales charge. This is a charge for selling your shares in the fund. Often, the charge can run as high as 4% to 5%, but it may be reduced the longer you own the fund. Many true no-load funds have no redemption fees, and some funds have no redemption fees except for perhaps a 1% fee for investors who hold shares in the fund for less than six months or a year. These time-dependent redemption fees are designed to discourage investors from trying to time the market by jumping from one fund to another since that could leave fund managers guessing about exactly how much money they have to work with.
The best no-load funds let you reinvest distributions free of charge, redeem your shares free of charge after six months or so, and shift money from one fund to another in the same fund family free of charge. Plus, if you've got more than a certain amount invested (say $2,500) or have the money in an Individual Retirement Account (IRA), the fund doesn't stick you with any "maintenance fees" just to mail you quarterly reports.
So far so good, but now you must take a close look at the section on Annual Fund Expenses. If the fund isn't hitting you with transaction costs, it's got to hit you with operating expenses, and you must determine whether they look reasonable. The three ingredients in this part of the mix are the management fee, marketing or 12b-1 fee, and other expenses. Each is measured as a percentage of the fund's average net assets and are payable every year. Such recurring costs can add up to much more than even exorbitant transaction charges. The management fee is what you're paying to the folks actually making the investment decisions (and their bosses). Summer houses in the Hamptons and trips to Aspen aren't cheap, so the management fee may represent half or more of total annual expenses.
Another healthy chunk will probably go to good old 12b-1, which is basically the Securities and Exchange Commission (SEC) rule that allows funds to charge you up to 1% of assets per year for the cost of marketing the fund to you and other shareholders. That's right, funds charge you for the cost of reeling you in. Revenues generated under 12b-1 may go to pay the broker who sold you on the fund or for that slick advertising on CNBC that originally caught your eye or that glossy brochure the investment company mailed you.
Finally, other expenses include various administrative costs such as keeping shareholder records, sending out financial reports, filing documents with the SEC, and paying for the service department that suggests you might want to just have a smoke when the Dow is down 500 points and you're wondering if maybe your backyard might have been a better place to put your money.
All of these annual expenses get tallied up as a percent of assets under management, with the handy table showing what this will cost you in real money per $1,000 over the next few years, so you can compare operating expenses at different funds. Perhaps a better comparison, though, is to remember that the Vanguard S&P 500 Index's annual expenses amount to just 0.19% of assets. When considering a new fund, it's also important to see if some of the annual fees have been temporarily reduced. That may sound good, and it is, except it may overstate the fund's current returns while setting you up to reimburse the fund company for these expenses at a later date.
So far you know what the fund is going to cost you. Now you want to find out what investment strategy the fund uses. You probably already have a general sense of this because you've already done some homework before you thought about getting cozy with any prospectus. You likely determined what type of fund you were looking for (for example, growth and income, growth, or aggressive growth) and then used some kind of screening tool to find the funds in that category that have delivered the best results in the past (say, over the last year, five years, and ten years). In other words, you didn't just pick up a copy of The Brothers Karamazov Fund prospectus because it sounded like part of a heartwarming fund family. Rather, you heard that this guy Dostoevsky was a bit of genius, and you saw his fund near the top of the charts.
The sections of the prospectus dealing with the fund's investment strategy and accompanying risks and the following section on the fund's management are where you go to get the skinny on who's running the fund and how they're running it. It's where you find out that this Dostoevsky fellow doesn't just invest in small-cap growth companies (say, small publishing firms), but also engages in a fair amount of gambling by trading futures and options, taking short positions, and using a fair amount of margin. Despite those great results, perhaps Dostoevsky is a bit too crazed for your liking.
The prospectus won't detail actual fund holdings, but it will describe the fund's objective and the game plan for achieving it, including some definitions and limitations. For example, this section might tell you that when the fund says "small-cap," it means any company with a market capitalization below $1.5 billion. Also, it may plan to have at least 80% of assets invested in such small-caps at any given time, but it won't necessarily sell stocks that appreciate in price so that they outgrow the fund's small-cap definition.
The nuts and bolts of the fund's results, though, are listed in a preceding table, usually under Financial Highlights, where you will find detailed financial information going back ten years, or as long as the fund has been in existence. Look at the section on Selected Per-Share Data. The top line lists the fund's net asset value (NAV), which is effectively the price of a fund share at the beginning of the given year, or the value of all the securities owned by the fund divided by the number of fund shares outstanding. The rest of the table indicates the net investment income (the money left from stock dividends and interest income after paying fund expenses), the net realized and unrealized gain or loss on investments (the profits on securities sold plus unrealized profits on securities currently held minus losses on securities sold and unrealized losses on current holdings), and the sum of these parts.
You could just add this sum to the old NAV to get the new NAV except that mutual funds have to distribute 98% of their income and dividends each year. The less distributions section accounts for this fact. The total distributions will include net realized gains after subtracting realized losses plus the net investment income. The numbers may not jibe exactly with the above income figure because investment income may be recorded according to the fund's fiscal year, but it must be distributed based on a calendar year. The total return is simply the percent return for the given year assuming that all distributions had been reinvested. This is the number you should compare with other similar funds or with the S&P 500 for the same period. It's crucial to remember, however, that total return discounts the annual management expenses but not the transaction charges, which could still eat away at even a strong return.
The next part of the table, Ratios and Supplemental Data, includes three other numbers of particular interest. First is the ratio of expenses to average net assets. These expenses include management, 12b-1, and the above other fees, but not loads or redemption fees. Though by some calculations expenses run around 1.5% at the average equity fund, you should look for funds with expenses around 1% or less. The expense ratio should also be declining over the years since as a fund's assets increase, the investment company ought to be able to squeeze out some economies of scale.
The ratio of net investment income to average net assets is akin to the fund's annual dividend yield. For an income-oriented fund, one would expect a ratio around maybe 2% to 4% whereas for an aggressive growth fund, a ratio around 1% or less would be more common. Another number often underemphasized by investors is the portfolio turnover rate, which gives in percentage terms the amount of total assets that were shifted from one investment to another in the last year. A figure above 100% indicates that essentially the entire portfolio was turned over, whereas a string of years showing low turnover, say around 30%, would indicate the fund manager doesn't trade in and out of stocks but is more comfortable making long-term investments that she doesn't have to mess with for a while.
Checking for a pattern in the turnover rate is important not just for what it tells you about your fund manager's investment style but for what it tells you about your likely tax hit. An investor only pays taxes on the fund's income and capital gains distributions (which usually come in December). A fund that doesn't do a lot of trading will more than likely have higher unrealized gains and thus smaller distributions. When two funds generate similar total returns, the fund investor will generally come out better with the fund experiencing low turnover because assets won't be diminished as often along the way by tax hits, and when the tax hits come, they are likely to be lower since long-term holdings will benefit from the lower capital gains tax rate. Also, more trading means higher commission costs. Though the fund pays less to trade than you do because it deals in volume, increased transaction costs from high turnover mean the fund manager has to do a little bit better just to keep up with the averages.
Between expenses, returns, and investment strategy, you've pretty much milked the prospectus for most of what it's worth. A prospectus offers other information about the fund, such as how to buy and redeem shares, what your shareholder voting rights are, and other stuff that's worth knowing if you think this is the one for you. Plus, each fund also submits a Statement of Additional Information (SAI) that can be obtained by contacting the investment company or by visiting the SEC's website. The SAI goes into much greater detail about many matters found in the prospectus, particularly the tax consequences of fund distributions, but generally in a language that only a lawyer could love. If you think there's any chance you will want to sue your mutual fund company sometime down the road, be sure to read the SAI carefully since it's legally considered part of the prospectus.
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