Mutual fund prospectus primer


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If your attempts to examine the prospectuses and shareholder reports you get from mutual fund companies have left you cross-eyed, confused and wishing for “CliffsNotes,” don’t toss them into the recycle bin just yet.

Like a student who knows how to pick out just the parts of a lesson that are going to be on the test, you can extract the essential content from these documents with a little guidance and without having to digest them whole.

Federal law requires that all mutual funds provide a free prospectus and shareholder report to every current or prospective investor.

Relevant fund communications
  • Know your goals, risk tolerance
  • Read the investment policy
  • Check out fund management
  • Note fees and expenses
  • Returns an important gauge
  • Pay attention to turnover
  • Read letter to shareholders

The prospectus describes the fund’s goals and objectives, lists the fees and expenses that are associated with the fund, explains its investment strategies and risks, and tells you how to buy and sell shares. Annual and semiannual shareholder reports give an account of the fund’s recent performance.

The prospectus describes the fund’s goals and objectives, lists the fees and expenses that are associated with the fund, explains its investment strategies and risks, and tells you how to buy and sell shares. Annual and semiannual shareholder reports give an account of the fund’s recent performance.

Know your goals, risk tolerance

A prospectus can be helpful, but it will not make much sense unless you first get a clear understanding of your investment goals.

“I tell the class that I teach, ‘Before you read any prospectus, you want to know why you’re investing and what your risk tolerance is,'” says Bob Mecca, a Certified Financial Planner professional, president of Robert A. Mecca & Associates in Hoffman Estates, Illinois, and author of the e-newsletter “Mecca on Mondays.”

“Let’s say that somebody is investing in an IRA. It’s a long-term investment of several years, and they are a moderate risk taker. When they read the prospectus, if it’s aggressive, small-cap, high-turnover, they just reject it and go to something else. You cannot read a prospectus without first understanding yourself.”

When you’re ready to start poring over a prospectus, pay special attention to information about the investment policy, fund managers, fees and expenses, returns and turnover.

Read the investment policy

In describing its investment policy, a mutual fund’s prospectus will lay out the parameters in which fund managers will choose investments.

“Some companies will say, ‘We can’t have more than 50 percent in junk bonds,’ or ’50 percent is going to be in U.S. Treasuries,'” Place says. “Some funds will be able to invest in just about anything.”

An aggressive fund manager may have wide latitude in picking companies for the fund. For example, Jim Saulnier, an independent Certified Financial Planner in Fort Collins, Colorado, recalls one real estate fund manager who expanded the definition of that category to include mining and coal companies — both part of “the land,” the manager reasoned. But some investors may have been surprised to learn that’s what they were getting into. “Make sure you’re comfortable with what the fund has the capability of doing,” Saulnier says.

Check out fund management

The prospectus will tell you who manages the portfolio and how long the manager has been on the job. Some funds are managed by one person, others by a group.

“There is a certain strength to the group approach,” Saulnier says. “The problem with an individual manager … is that when that person leaves, it blows out the entire fund potential.”

With a group of managers, even if one “star” manager leaves, the others can still maintain the continuity of the investment strategy.

As far as experience is concerned, Mecca says the more, the better. “I want someone who’s been through it, has seen it and knows how to react to it,” he says. “Somebody who just gets out of school and has one to two years of experience, that’s a negative to me.”

On the other hand, Randy Kurtz, founder and chief investment officer of BetaFrontier — formerly RK Investment Advisors — in New York, says a little freshness isn’t necessarily a bad thing.

“There are two ways of looking at that,” Kurtz says. “Experience is always good … yet there have been studies that say that, on average, managers’ best performances are early in their (careers).”

It’s essential to know how long the manager or group of managers has been at a fund in relation to the period of performance you’re evaluating.

“You need to make sure that the performance you’re looking at is attributable to the people who are currently managing the fund,” Kurtz says. “If they’ve only been on the fund for two years, you can’t look at the five-year track record.”

Note fees and expenses

The fund and its managers look like a good fit for your investment goals. Now you want to check out the price tag. A host of transaction fees and operating expenses may apply.

Shareholder fees, which are charged directly to the investor when a transaction is made, include:

  • Sales loads or commissions to brokers selling the fund. Can be paid upon purchase, known as front-end, or when the shares are redeemed, or back-end.
  • Redemption fees, paid to the fund rather than broker to defray the cost of redeeming shares.
  • Exchange fees. Charged when shares are transferred to another fund in the same fund group.
  • Account fees. Typically incurred for account maintenance if a minimum balance is not maintained.
  • Purchase fees. Paid to the fund to defray the cost of purchasing shares.


Separately, a fund’s annual expense ratio is deducted from fund assets and comprises fees associated with fund management as well as 12b-1 fees, if applicable. The expense ratio also includes operating expenses, such as legal, accounting and auditing fees.

Sales loads, based on a percentage of the purchase amount, vary from one type of fund to another, says Wade Slome, president and founder of Sidoxia Capital Management in Newport Beach, California.

A front-end sales load typically costs 5 percent, but another type of sales load is buried in the expense ratio. Known as 12b-1 fees, they are used to compensate brokers or to cover expenses for marketing the funds.

“Your general equity fund, while I wouldn’t use this as a hard and fast rule, charges anywhere from 75 basis points to 125 basis points, or 0.75 percent to 1.25 percent,” Slome says, referring to total expense ratios, including 12b-1 and management fees. “You could probably subtract 50 basis points, or 0.5 percent, from that range to kind of get the (sales load for the) fixed-income bond fund.”

Not all funds charge fees on sales. Those that don’t are called no-load funds. These can be purchased directly by individual investors from a fund company without a broker or adviser.

In cases where sales loads apply, Place suggests checking the prospectus for information on break points, or sales fee discounts for purchasing a minimum dollar amount in shares.

Returns an important gauge

While fees matter, Mecca says it’s important to put them in context. “Sometimes people tend to make investment decisions (by picking) the lowest management fees,” he says. “We think that’s a recipe for disaster. We look at the greatest net return. Let’s say Mutual Fund A has a management fee of 0.7 percent, and the returns are 10 percent. That means the net is 9.3 percent. Let’s say Mutual Fund B has a management fee of 1.5 percent, but its returns have averaged 13 percent. Now you have a net return that’s even higher than the other one.”

Mutual fund returns are always expressed net of expenses, or after expenses are deducted.

It’s difficult to know in advance which funds with high expense ratios will wildly outperform their benchmarks or their peers. Advisers have to depend on past performance, and the caveat, “the fund’s past performance does not necessarily predict future results,” is included in fund literature — an SEC requirement.

For that reason, many advisers choose for their clients no-load funds with low expenses as well as consistent, risk-adjusted returns.

Slome firmly believes that “the no-load is the best way” because it means lower fees. “By calling up the 800 number of a mutual fund company, the investor can avoid paying a middleman broker a load fee,” he says. “The reason that some investors pay a load fee is because they are supposedly paying the broker for the advice of which fund to buy.”

When choosing funds for clients, Mecca likes to look at returns over a 10-year period and compare the fund’s performance to that of the relevant index over the same period.

“If it’s underperformed more than three times, then I usually don’t like the fund,” Mecca says. “Seven out of the last 10 years, I’d like it to outperform the index.”

Pay attention to turnover

Along with finding out what you’ll have to pay to invest in a mutual fund and what you may have a chance to get out of it, you’ll want to investigate the potential tax implications. The fund’s turnover rate is a big clue. A high turnover, or more frequent sales, can mean higher capital gains taxes for money held in a brokerage account outside of a tax-favorable plan. For tax-deferred accounts like 401(k)s and IRAs, turnover is less of a concern.

“If the fund has high turnover, you probably would not want to invest in it, unless it’s an IRA or a (tax) qualified plan,” Mecca says. “If it has high turnover and you invest in it nonqualified (outside of a tax-favored retirement plan), you’re going to get hammered in taxes.”

A 100 percent turnover rate means the average stock in the fund portfolio is held for one year before selling, Slome says. If the turnover rate is 25 percent, stocks are held an average of four years.

“Some funds will have 300 percent to 400 percent turnover, so they only hold stocks for three or four months,” Slome says. “At the end of the year, investors are surprised when they get this big fat tax bill.” This can happen even when the market is down for the year.

Another tax-related issue to consider is the fund’s capital gain distribution schedule. If you receive a capital gain following the purchase of a fund, you will incur a tax, even if you didn’t own the shares at the time the gain was realized.

“Some mutual funds will (distribute capital gains) as early as October,” Place says. “I’ve seen in the past where people have purchased a fund and had a little bit of a surprise.”

Even in tax-deferred accounts, turnover is an issue because the fund incurs transaction costs, and while fund investors don’t pay it directly, they pay for it with lower returns. In his book “The Little Book of Common Sense Investing,” John Bogle, founder of The Vanguard Group and proponent of low-turnover index funds, estimates that “turnover costs are roughly 0.5 percent on each purchase and sale, meaning that a fund with 100 percent portfolio turnover would carry a cost to shareholders of about 1 percent of assets, year after year.”

In short, high turnover funds can cost investors a lot of money over time.

Read letter to shareholders

Once you invest in a mutual fund, you’ll start receiving annual, and perhaps semiannual, editions of another chunky document: the shareholder report. The good news is that it’s perfectly OK to skip a lot of what’s in these reports.

Slome says the letter to shareholders in the annual report provides a general assessment that’s like a view from 10,000 feet. “It will tell you what’s worked in the economy, what hasn’t worked, what’s impacted the performance of the fund,” he says. “It will usually talk about the macro-economic environment.”

Saulnier and Mecca agree that the letter is a good place to start, and they don’t see much point in going any further. Apart from the letter, Saulnier says, the annual report is filled mainly with “financial gobbledygook.”

And Mecca adds: “I don’t put a lot of credence in the annual report. By the time it’s printed and sent out, things change. Annual reports, in my opinion, are just marketing pieces to show at any one particular time what the asset allocation was, and specific details of where the investments were made.”

Once you learn to separate the fiber from the fluff in a mutual fund report, you can do more than just build your biceps when you pick up one of the colossal documents. You can actually get from it what you need to know to create a healthy investment plan.