10/1/2008 9:00 AM ET|
Mutual fund documents, Part 1
FUNDS 108: You need three valuable fund documents, produced by the company running your mutual fund: The prospectus, the Statement of Additional Information, and the annual report.
You've heard the pundits on TV -- Five stars! -- when giving their hot pick of the month. And you probably know one or two lucky co-workers who made a mint at some point after taking a chance on some fund or another. But you can't have missed the recent tales about the downfalls of yesterday's favorite fund shops, the management scandals and the huge, risky bets that cost many investors their retirement dreams.
Clearly, the experience of recent years suggests that investors need more than performance numbers and hot tips to judge a fund.
Before parting with your money, you need to be able to answer questions such as: What is the fund's investment strategy? What are that strategy's risks? How much does the fund cost? How does this fit in with my goals? And who runs the thing, anyway?
In order to answer these questions you need three valuable fund documents, produced by the company running your mutual fund: the prospectus, the Statement of Additional Information and the annual report.
When you request an information kit from a fund family, you'll usually receive the prospectus and the most recent shareholder report. (Many fund companies also make these documents available on their websites.) These documents are packed with legal jargon, convoluted sentences and boilerplate information in order to fulfill the Securities and Exchange Commission's disclosure requirements and to protect the funds from legal liability. The language can be tremendously intimidating -- and reading it is dull work.
But these documents are vital for mutual fund investors.
Here's how to get what you need from the prospectus and the Statement of Additional Information. (We'll cover the annual shareholder report in our next lesson.)
The prospectus tells you how to open an account (including minimum-investment requirements), how to purchase or redeem shares and how to contact shareholder services.
It also details six aspects of the fund that you need to know about before you decide to buy shares.
1. Investment objective. The investment objective is the mutual fund's purpose. Is the fund seeking to make money over the long term? Is it trying to provide its shareholders regular income each month? If you're investing for a young child's education, you'll want the former. If you're looking for a monthly dividend check, you'll want the latter. But investment objectives are often vague. That's why you'll want to check out the next section.
2. Strategy. The prospectus also describes the types of stocks, bonds or other securities in which the fund plans to invest. (It does not list the exact stocks that the fund owns, though.) Stock funds identify the kinds of companies they look for, such as small, fast-growing or big, well-established corporations. Bond funds specify what sorts of bonds they generally hold, such as Treasury or corporate bonds. If the fund can invest in foreign securities, the prospectus says so. Most (but not all) restrictions placed on the fund are also mentioned here, including references to short selling, leveraged purchases and so on.
3. Risks. This section may be the most important part of the prospectus, but it's generally written in very broad language. Every investment carries risk and a prospectus must explain these risks. For instance, a prospectus for a fund that invests in emerging markets will reveal that the fund is likely to be riskier than a fund that invests in developed countries. Bond-fund prospectuses typically discuss the credit quality of the bonds in the fund's portfolio, as well as how a change in interest rates might affect the value of its holdings.
4. Expenses. It costs money to invest in a mutual fund, and different funds have different fees. A table at the front of every prospectus makes it easy to compare the cost of one fund with another. Here, you'll find the sales commission the fund charges, if any, for buying or selling shares. The prospectus also tells you, in percentage terms, the amount deducted from the fund's return each year to pay for things such as management fees and operational costs.
5. Past performance. We all know the fund world's catch-all phrase: "Past performance is no guarantee of future results." But a fund's record can give you an idea of how consistent its performance has been. A chart known as the "financial highlights" or "per-share data table" provides the fund's total return for each of the past 10 years, along with other useful information. It also breaks out the fund's income distributions and provides the year-end net asset value.
Some prospectuses include additional return information in the form of a bar chart, which illustrates the fund's calendar-year returns for the past 10 years. This chart is a good way to get a handle on the magnitude of a fund's ups and downs over time. The prospectus may also use a growth of $10,000 graph (also known as a mountain graph, because the peaks and valleys resemble the cross section of a mountain) or a table comparing the fund's performance to indexes or other benchmarks to present return information. (Unless otherwise stated, total return numbers do not take sales charges into account, but they do take into account a fund's annual expense ratio.)
6. Management. The management section profiles the folks who will be putting your money to work. At this point, many funds identify the name and experience of the fund manager or managers. However, some funds simply list "management team" or some other less-than-helpful phrase.
Also consider the fund manager's tenure -- if it's relatively short, the fund's past record may have been achieved under someone else. Find out whether the manager has run other funds in the past. A peek at those funds could give you some clues about the manager's investment style and past success.
Statement of additional information
While the prospectus is packed with great information, it shouldn't be your sole source. A fund's Statement of Additional Information (SAI) contains more great tidbits about the fund's inner workings. You'll generally have to request this document by calling the fund company: Funds send out prospectuses and annual reports as a matter of routine, but SAIs are often considered second-tier documents.
Fund families may consider SAIs secondary, but these statements usually provide far more detail than the prospectus about what the fund can and cannot invest in. Further, this document usually identifies just who represents your interests on the fund's board of directors -- and just how much you pay them for their efforts and how much these directors own of the fund.
Finally, you can find more details about your fund's expenses here. Shareholders in
Putnam Fund for Growth and Income (PGRWX) wouldn't know they shelled out $28 million in brokerage fees in 2001 unless they had read the fund's SAI. SAIs also break down where 12b-1 fees go, if the fund charges them. (These are fees that the fund can use for marketing, rewarding brokers, and attracting more investors.) For example, Legg Mason Capital Management Value Trust (LMVTX) spent $49 million of the $96 million in 12b-1 fees it collected in 2002 compensating brokers for selling the fund. It's your money; you should know where it's going.
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