How to Read a Prospectus
Once you’ve already made an investment in a fund, however, is hardly the best time to look over the company’s information. Investment companies will issue you a prospectus upon request, so that you can look over their financial information and make an educated decision on whether or not to invest.
If you have never looked at a prospectus before, it might seem a little daunting at first. Little more than a series of tables and numbers that could as well be Greek. Prospectuses don’t have to be that difficult to read, though. Essentially any prospectus is going to give you information on three key areas:
Investment strategies and goals of the fund
Past performance records of the fund
Fees and expenses associated with investing in the fund
Investment Strategies and Goals
This section of the prospectus tells you what the goals of the fund are (i.e. growth, value, etc.) and where the fund is putting all of those investment dollars. Bonds, commodities, industrial companies, overseas markets, etc.
It’s always important to look closely at the type of investments the company is putting your money in. Probably you already have some sense of the company’s strategy if you are looking to invest your own money in it, but you might find some surprises here. Perhaps some of the company’s investments sound a little too risky for you, even though are you looking for an aggressive growth fund. Or perhaps it overplays bonds more than you are looking for. It’s always a good idea to know where your money is going to go.
Past Performance
Past performance is perhaps the best gauge on how successful your investment will be. Strategy is one thing, actual performance is quite another. Assuming you’ve been doing your homework, you should already have a good idea of a fund’s past performance before receiving the prospectus, but it is always good to take a closer look.
To make things easier on you the SEC requires that the prospectus include a bar graph showing the past ten years of performance for the fund. (Or the life of the fund if it is under ten years old). This is a simple, easy to read way to show just how the fund has been doing.
The prospectus will also include a table demonstrating returns before and after taxes for 1, 5 and 10 year intervals, and provides similar information based on a broad index to give you a comparison.
When looking at the past performance records, you are almost always going to see a footnote somewhere that says something to the effect of Past performance is no guarantee of future performance. Always keep that in mind. Just because a fund has shown 15% returns for the past ten years doesn’t mean they are going to do the same for the next ten years. Even the safest looking investment contains some element of risk. You never know what the markets are going to do.
Fees and Expenses
Now we’re getting to the real nitty gritty of the prospectus. Assuming that you have a well-performing fund, you are going to want to make sure that you are paying as little as possible for your investment. Nothing eats more into your investment than fees and expenses. Typically fees and expenses are separated into two categories: Shareholder transaction expenses and operating fees.
Shareholder Transaction Expenses
These are the basic expenses that are charged to you just for making transactions in the fund, beginning with your initial investment and also including reinvestment of dividends, redemption fees and exchange fees.
Generally speaking these expenses are given in percentages. For example, if there is an 8.5% fee on initial investment in the fund, and you invest $10,000 to start off, you will be charged $850, and you will be left with $9,150 in your account. You will be charged again every time you put your dividends back into the fund, if you want to move your funds to another account within the company or when you want to withdraw your funds. All of these fees eat into your investment.
Fortunately these sort of fees are not a requirement. Funds that charge these sort of expenses are called load funds. Since the 1970’s there have been a growing number of no load funds that charge no transaction expenses, saving you a lot of money. In order for a load fund to earn you more money (after expenses) than a no load fund it must greatly outperform it and as of now there has been no evidence that they do that on any sort of consistent basis. Basically if you want to invest you should invest in a no load fund, and then you will not have to worry about any sort of transaction expenses at all.
Operating Expenses
Operating expenses are the fees that will be charged to you on a constant basis. This is how the investment company makes money (along with the transaction expenses if it is a load fund). The biggest chunk of operating expenses generally goes to management fees, however there are other expenses as well. The prospectus will inform you of exactly what these expenses are for.
Like the transaction expenses operating expenses are given in a form of percentages. All of the expenses are added up to give a total operating cost. Generally this will rest somewhere between 0.5-2.0% (although there are many funds that charge much less, particularly index funds that charge as little as 0.2%).
These operating expenses are taken from the total value of the fund. The lower the percentage, the better for your investment.
Summary
Reading the prospectus is essential before investing in any funds. You want to find a fund that delivers strong performance, charges you as little as possible and is in line with your own investment goals. There is no better source of information for this than the prospectus.
