{"id":3556,"date":"2009-04-23T05:00:31","date_gmt":"2009-04-23T12:00:31","guid":{"rendered":"http:\/\/getrichslowly.org\/blog\/?p=3556"},"modified":"2019-10-15T21:29:48","modified_gmt":"2019-10-16T04:29:48","slug":"how-to-read-a-mutual-fund-prospectus","status":"publish","type":"post","link":"https:\/\/www.getrichslowly.org\/how-to-read-a-mutual-fund-prospectus\/","title":{"rendered":"How to read a mutual fund prospectus"},"content":{"rendered":"

If we’ve learned anything from the current financial crisis, we’ve learned that it’s important to understand what it is we’re actually investing in<\/b>. No more black-box investing, right? That’s true of the folks on Wall Street, but it’s also true of the average mutual-fund investor, too.<\/p>\n

If you invest in mutual funds and you want to understand what you are about to buy, you’ll have to thumb through the prospectus and Statement of Additional Information. These two documents tell you what the fund managers intend to do with your money \u2014 and how much they’re going to charge you for doing it. Unfortunately, this information is usually drowned in a soup of legalese, but the information is<\/i> there, and I’m going to show you how to find what you need in less than 10 minutes.<\/b><\/p>\n

You’ve probably heard the term prospectus<\/a>, but you may have never heard about the Statement of Additional Information<\/a> (SAI). The SAI is where the fund’s lawyers put all the information they want to hide from the avid prospectus-reading public.<\/p>\n

When you first think about actually reading a prospectus and SAI, you might be frightened. Buck up. We’re going to get through this together. There are really only a handful of items you need to be concerned with.<\/p>\n

<\/span>What Can the Fund Managers Do With Your Money?<\/span><\/h2>\n

Let’s consult the prospectus first. Go to your mutual fund’s website and download the fund prospectus and while you’re at it, get the Statement of Additional Information. For an example of a prospectus and SAI, take a look at those from the Vanguard Capital Value Fund<\/a>.<\/p>\n

If you turn to the Table of Contents (in the prospectus) you’ll probably see a section that talks about Risk\/Return. Each fund family uses different headings for the sections so you’ll just have to look around a little. If you don’t see a section heading for \u201cRisk\/Return\u201d, glance through the first several pages. You should see a discussion about Investment Objectives, Primary Strategies, and Primary Risks. I downloaded the prospectus of a very popular large-cap growth fund (not<\/i> the one linked above) and turned to the risk section.<\/p>\n

Under that section, I found a brief description of the main objective of the fund. But buried in the third paragraph I also found this little goodie:<\/p>\n

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Interesting, huh? What you’re buying today may not be what you own tomorrow. I continued by looking at the “Investment Policies and Restrictions” section in the SAI. When I did, here’s what I found:<\/p>\n

Each Fund may invest up to 15% of its net assets in illiquid investments (i.e., securities that are not readily marketable).<\/p><\/blockquote>\n

This particular SAI also pointed out that the fund may put up to 20% of its assets into High-Yield-Risk Bonds, it may invest in futures contacts, and may invest in other mutual funds. I also found that the fund can sell securities short.<\/p>\n

When you read the section in the prospectus about risk\/reward and the section in the SAI about Investment Policies and Restrictions, you may not be familiar with all of the terms. High-yield bonds? Futures? Selling short? What’s all that? Rather than enroll in the nearest MBA program you can find, I would approach it as follows.<\/p>\n

The \u201cRisk\u201d and the \u201cInvestment Policies\u201d sections are there to point out the risks you take when you buy the fund. If they mention something in these sections that you don’t understand, either call the fund company and ask them what it means or find another fund. If you call the company, ask what the risks of these other investments are. Never buy a fund if you don’t understand what they do with your money.<\/b> (As an added bonus, if you follow this rule, you’ll never be a victim of a Ponzi scheme<\/a>.)<\/p>\n

Once you understand what the company does with your money, make sure it’s consistent with your ultimate goals. For example, let’s say you want to buy a fund that invests in large, well-established companies. You’ve done your homework and you are comfortable with the risks of doing that. If you read the prospectus and it mentions that the fund can also invest in other areas, you may want to pass. Why? Because it may be investing in areas that have much greater risk than you are comfortable taking.<\/p>\n

<\/span>What Are the Fund’s Investment Returns?<\/span><\/h2>\n

In most cases, the information about investment returns is straightforward and easy to understand. Here’s a peek at the returns section from the prospectus I downloaded.<\/p>\n

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First look at the \u201cReturns Before Taxes\u201d and compare the numbers to the Russell 1000 and S&P 500 Index numbers. Compare the before tax numbers because the indexes are also all before tax.<\/p>\n

You can see that this fund out-performed the indexes in 1-, 5-, and 10-year periods and also since inception. That’s encouraging. The question is whether or not the fund is being compared to the correct index. You’ll get a feel for that by reading the \u201cFund Profile\u201d in the prospectus. For example, if you are considering investing in a fund that buys shares in small cap international companies, the prospectus shouldn’t compare its performance to the S&P 500.<\/p>\n

While these 1-, 5-, and 10-year averages are helpful, the yearly numbers are more important. You see that information in the blue graph. This tells you how the fund did in each of the last several years. You can see how the fund did in good and bad years. For example, in 2002 the fund lost 27% and in 2003 it was up 31%. Is that volatility in line with your appetite for risk? If not, look for a different fund.<\/p>\n

Conclusion? Read the Risk\/Return section of the prospectus and the Investment Policies and Restrictions in the SAI.<\/b> Again, the fund families use different topic headings but with a little common sense, you’ll pinpoint this information. This will tell you what the fund can and can not do with your money. It will also tell you how they performed. Once you review this, you might find that your fund leaves you with a bad taste in your mouth.<\/p>\n

<\/span>What Are the Fees and Expenses?<\/span><\/h2>\n

There are two types of fees:<\/p>\n