What’s In a Mutual Fund’s Prospectus
Posted by Gail | Filed under Investing
Picnic info to follow
Legally, mutual-fund sellers are required to provide you with a copy of the prospectus before you buy. Read it. This is the step investors often skip. They site the fact that it’s boring, that it’s written financial jargon, that it’s complicated. But if you’re making any excuse about not reading the prospectus, you should not be investing in mutual funds. If you’re prepared to pour your hard-earned money into a fund, you should at least be prepared to spend some time learning the facts. So what exactly will the prospectus tell you? It’ll answer the six most important questions you should be asking about the fund.
1. What are the fund’s investment objectives? Is the fund trying to make money over a long-term period through capital appreciation, or is it trying to provide a regular cash flow each month? If you’re investing for your retirement, you’ll want the former. If you’re already retired and need a steady source of income, you’ll want the latter.
2. What’s the fund’s strategy? Since investment objectives have a tendency to be somewhat vague, the fund’s strategy will tell you more about what you can expect. The prospectus describes the types of securities that will be held. If the fund buys equities, the prospectus will describe whether the manager is looking for a small, fast-growing company or one that will already well established. A bond fund will specify whether holdings will include corporate or government bonds, or both. And the prospectus will specify whether foreign securities will be included as part of the portfolio. More information on what the fund may invest in are included in the funds Statement of Additional Information, which deals with complex items not directly pertinent to the investment decision: biographies of directors and officers, all the expense items, contract provisions of the agreement between the advisor, the fund and audited financial statements.
3. What are the risks associated with this fund? Since every investment has some form of risk associated with it, it makes good sense to understand what the risks are inherent in the fund you are considering. A fund that invests in emerging markets will say that this type of investment is riskier than investments in developed countries. The prospectus for a bond fund will describe the credit quality of the bonds in the fund’s portfolio, as well as how a change in interest rates might effect the value of its holdings. You need to understand all the risks involved with a fund’s investment style before you buy the fund. And you need to be very clear on your risk tolerance before you choose the specific fund you’ll plunge into.
4. What are the fund’s expenses? Nothing in life is free, and it can costs lotsnlotsa money to invest in a mutual fund. From sales charges or commissions to the Management Expense Ratio (MER), the costs will be itemized. The prospectus also states in percentage terms the Management Expense Ratio or MER, which is the amount deducted from the fund’s return each year to pay for things such as operation costs.
Many mutual funds charge a sales fee — sometimes called a “commission,” “acquisition fee” or “load” — on the sale of their funds. Some funds have an initial sales charge — called a front-end load, or an “in” — which is charged on the amount originally invested. Some funds charge a redemption fee — referred to as a back-end load, or an “out” — and this is payable when the units of a fund are redeemed, or sold. It may be calculated on the initial purchase cost on the value of the investment when it is sold, which, of course, would make it higher. Most redemption fees are usually designed to reduce to zero after the fund has been held for a specific number of years. Funds that have the commission paid spaced evenly over the time you own the fund are referred to as having level loads. Commissions paid on the purchase or sale of a mutual fund can have a significant impact on the return earned on the investment. If you decided to invest $3,500 in a front-end loaded mutual fund with a commission of 9%, of your initial investment, $315 went to pay the front-end load. Because commissions are taken directly from the amount being invested, you would really only invest $3,185 in the fund itself. Mutual funds that charge no commission to buy or sell the units are called “no-load” funds. This means there is no cost to you to buy or sell the units or transfer between funds in the same family. This also means that every dollar you invest goes to work to produce a return.
People hate paying fees of any kind. And you’ll see myriad articles written about why you shouldn’t buy a loaded mutual fund, and how high management expense ratios are steeling money out of your pocket. Yes, a no-load fund does put all your money to work for you. And yes, high MERs do reduce the return of the fund. Taken together these numbers tell one story (as in, what about the no-load fund with the high MER), but that’s still only part of the story. Overall fund performance, good management, strong year-by-year numbers (showing low volatility and consistency) must weigh heavily in your decision. There’s no question that the commission structure of the fund and the MERs charged should be part of your consideration because it does affect the real return you receive. But fees can’t be the only criteria you use to make decisions about the funds that you will buy.
Keep in mind that while some funds do not charge commission, they may instead charge a set-up fee. Others charge transfer fees for the privilege of transferring from one fund to another within the same group or family of funds. Finally, some mutual funds charge a termination fee to cover the administrative expense of closing an account.
5. What’s the fund’s past performance been like? While past performance cannot guarantee future results, it can give you a good idea of how consistent a fund’s returns have been. However, the average return that is so often used to show a mutual fund’s performance only tells a small part of the story. It does nothing to show the volatility of the fund (how much the annual returns varied). For this you must look at year-by-year returns. Also remember that total-return numbers, unless otherwise stated, do not take sales charges into account.
As part of your understanding the performance numbers, you should also understand how a fund’s simple and total rates of return are calculated. Simple rate of return measures the appreciation or depreciation of the unit value of the fund over the period (typically one year, three months and year-to-date). The simple rate of return on an equity-based mutual-fund unit is calculated by dividing the capital gain/loss realized by the purchase price and multiplying by 100. If, for example, you buy an equity fund for $10 a unit and you sell it for $12, then your simple rate of return is 20%.
Total rate of return measures the annual total return to investors. It includes capital appreciation or depreciation, plus interest, dividend and capital gains distributions, which are assumed to be reinvested quarterly. The total rate of return on an equity-based mutual fund is calculated by adding together the total dividends paid and the capital appreciation (or loss), dividing it by the purchase price and multiplying it by 100. If, for example, you buy an equity fund for $10 a unit, it pays a dividend of $0.25, and you sell the unit for $12, then your total rate of return would be 22.5%.
6. Who is managing the fund? Remember that expert financial manager with eons of experience mentioned earlier, this is him or her (or them, in a lot of cases). It’s nice if the prospectus actually tells you the name and experience of the fund manager or managers. However, some fund’s simply list “management team” or some other less-than-helpful phrase. Look at the fund’s Statement of Additional Information or annual report and you’ll find more specific information. Or call up the fund company and ask for a bio. What you’re looking for specifically is how long the manager has been running the fund. If the fund has been doing well, but has just been taken over by a new manager, the style change may affect the fund’s performance. If the fund has been doing badly, but there’s a new manager in the store, hey, things could move up. In either case, you’ll probably want to give this mutual fund some time to prove itself before you buy. If the manager has run other funds in the past, you can check the performance of those funds to see what his or her track record has been like. Remember to look year-by-year returns to see how well (or not) the manager has done.
You must, must, must read the prospectus, statement of additional information and annual report before you buy a fund. If you don’t you’re not buying, you’re being sold. That’s a passive act, and has no place in your I’m-in-control-of-my-money role. Do your homework. Know what you’re buying before you buy.
Next Week: Closed Funds
Last Week: Dollar Cost Averaging
The 2nd Annual Picnic in the Park
Date: Sunday, July 11, 2010 from 10 – 3
Where: High Park, Toronto – Area #3 and shelter – here is a map (Note the different location in the park.)
Rules:
- Zero tolerance alcohol policy
- All waste/recyclables must be placed in appropriate containers – if not available, must remove any waste at own cost
- No amplified music or microphones
- Park in designate parking areas only, no parking on grassy areas
- Sale of food/items not permitted
- Tables, BBQs and parking cannot be guaranteed
- No balloons, decorations or signage permitted
- Gas/propane BBQs only, no charcoal BBQs
- No inflatable games, dunk tanks, generators, tents or tarps
- No outside caterers
Food: Last time people brought an assortment of foods (apps, mains, desserts) and drinks and it worked out very well. Bring your own dishes and cutlery to minimize waste as we also did last time.
A huge “Thank you” to Saver Queen for setting this (and the last) picnic up and I’m looking forward to seeing so many of you there. Even if you can only make it for a couple of hours, it’s worth the drop-in since you’ll get to meet other people of a like mind who have funny stories to tell. Hugs will abound and picture-taking is welcome, though you should know I come as I am!
June 1, 2010 at 6:57 am
I always read the prospectus before moving money to a new mutual fund. They are kinda boring but I’ve caught a few where they were going in the wrong direction from where I really wanted to go. This helped me steer my boat in the correct direction by avoiding the worng funds.
regards,
Jason
June 1, 2010 at 7:58 am
I have been really surprised at the difference between the prospectuses of different mutual funds. Read a few, and you’ll get a feel for what should be there, and how one should look.
For example, one fund I looked at was really upfront about the risks you face as an investor in their funds, and breaks it down into the following categories with details:
• Below-Investment Grade Securities Risk
• Credit Risk
• Covered Call Option Risk
• Currency Risk
• Derivatives Risk
• Emerging Markets Risk
• Distressed Securities Risk
• Equity Risk
• Foreign Market Risk
• General Market Risk
• Interest Rate Risk
• Legal and Regulatory Risk
• Liquidity Risk
• Political Risk
• Prepayment Risk
• Refinancing Risk
• Securities Lending, Repurchase and Reverse Repurchase Risk
• Series Risk
The other (offered through a major bank) just says there might be some risk involved, and leaves you to deduce how much based on the fund’s past returns (up 45% one year, down 30% the next, up again by 10% the year after that).
They’re both targeting similar industries in similar countries, but they each have a very different philosophy when it comes to investor information.
Choose wisely!
June 1, 2010 at 12:52 pm
To pick up on Kate’s list:
I read the list and understand the meaning of SOME of these. Others… I am not sure until you get to hear the bad news that this type of risk is based on self-regulated industries.
Gail, it would be great if you could explain the details of the list that Kate wrote.
Also, the fund seems to do well… but if I don’t like ONE of the risks, what’s a girl to do? Many funds from the same category would presumably have the same risks?
June 1, 2010 at 1:49 pm
I’ve got quite a bit invested in mutual funds but I’ve been relying on my investment counsellor/company and have not been doing a good job of reading the prospectuses. Now I have some serious reading to do. I needed this push.
Thanks for the info about the July picnic. Just one concern- Area 3 is near a playground and splash pool and will probably not be very pleasant. A quieter location, away from noisy attractions, would be more relaxing and enjoyable.
June 1, 2010 at 4:15 pm
We missed the picnic last year so we’re planning on coming this year – but I love that its near a splash pad and playground as my daughter will probably have a better time than just standing around with a bunch of adults talking about money… although, she loves the jars and the fact that she gets an allowance. She thinks Gail is AWESOME! lol
June 1, 2010 at 4:19 pm
I always like to know what my money would be invested in. What companies? I avoid mutual funds that have investments in tobacco. That is a big no no for me. A couple other companies for personal reasons.
June 1, 2010 at 5:19 pm
Thank you for clearing up the murkey waters of the mutual fund prospectus for me.
June 2, 2010 at 10:56 am
@marie:
The Fund itself gives a great explanation of the risks. I don’t wan to copy their stuff without permission, so here’s the .pdf of the Prospectus (which explains the terms in detail).
http://www.choufunds.com/pdf/PROSPECTUS09.pdf
June 4, 2010 at 2:57 am
[...] What Is in a Mutual Fund’s Prospectus? Gail V-O does a quick outline, but in my estimation, point (4) is where you start from. [...]
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