How to Read a Mutual Fund Prospectus

Before a mutual fund is introduced in the market, fund managers need to decide on the investment objectives and the market strategies that need to be pursued in order to meet these objectives. The mutual fund prospectus is a valuable tool with all the relevant information such as investment objectives, expenses, portfolio holdings, fees and management that investors need to know in order to make a well-informed investment decision.

The Securities and Exchange Commission (SEC) requires that mutual fund companies provide investors with the mutual fund prospectus, written in “plain English” so that even an average investor can read and understand what the mutual fund is about, in what markets it invests and so on.

According to the Securities and Exchange Commission (SEC), the minimum information included in a mutual fund prospectus is the following:

(1) The fund’s investment objective such as total return, income and so on.

(2) The investment strategies that the investment company seek to pursue or the types of securities in which the fund will invest in order to meet its investment objectives.

(3) Major risks that investors will have to face by purchasing the fund such as effects of volatile markets, changing interest rates, changing exchange rates etc.

(4) Recent investment performance. When the mutual fund has an investment performance history, it is proper to include a SEC-mandated table in the prospectus to demonstrate the mutual fund’s performance over one, five, and ten years, compared to an appropriate market index return and an average return for mutual funds with similar objectives. Besides, the table must demonstrate the effects of any up-front commissions paid by investors at the beginning of any of the three above mentioned periods.

(5) Fees and expenses should be presented in a SEC-mandated table that would indicate how much of the fund’s returns are directed towards the payment of operating expenses, commissions, management fees and so on. Besides, the SEC requires a separate table that will demonstrate the hypothetical costs of the fees and expenses following an investment of $10,000 and assuming a 5 percent annual return.

There are numerous fees associated to the management of a mutual fund. Management fees range between 0.5 percent and 2 percent and are charged annually for the administration of the fund. Annual management fees include (a) the load fees (how much it costs to buy the fund), (b) the reinvestment fees (when investors reinvest their annual profits), (c) the redemption fees (the cost of selling shares of the fund) and (d) the exchange fees (the cost of moving money from one fund to another in the same family of funds)

(a) The load fees used to be around 8.5 percent of initial investment and most of these charges were actually the broker’s commission for opening the account. In the 1970s, some mutual funds companies started offering no-load funds, meaning upfront commission was not necessary to put the money into funds. However, the best way to go is to compare load and no-load funds because, after all, they are all making money.

(b) Reinvestment fees are charged for automatic reinvestment that allows investors to purchase additional shares using their capital gains or dividend distributions. Instead of collecting the money, investors reinvest it automatically into their mutual funds, thus acquitting more shares and avoiding excess taxes. Yet, there are fees associated with such transactions.

(c) Redemption fees, or deferred sales charges, can charge as high as 5 percent to 7 percent. Some funds do not have redemption fees, or as low as 1 percent for investor who hold the funds for less than a period of six months. The goal of redemption fees is to discourage frequent trading and investors from trying to time the market by changing positions from one fund to another.

(d) Exchange fees are charged when investors transfer their money from one fund to another within the same investment company.

Distribution and service fees, referred to as 12b-1 fees are allow funds to deduct up to 0.75 percent of average net assets per year to cover for distribution costs, advertising commissions and general marketing expenses. Revenues generated under 12b-1 typically pay the broker who sold the fund or towards TV advertisements that raise investor interest.

Besides above mentioned information, a mutual fund prospectus can include in detail how to redeem shares in the fund. Also, minimum investment requirements are listed, as well as shareholder programs explaining the information available and what options are available for investors by mail, phone or the Internet.

The most important part of the prospectus is the Financial Highlights section, where investors can find detailed financial information about the fund’s historical performance. In this section, investors can see the fund’s Net Asset Value (NAV), which is the total market value of the fund divided by the number of share outstanding. They can also see indicative information about the fund’s net investment income as well as net realized and unrealized gains / losses on investment.

One important consideration for investors when reading a mutual fund prospectus is the Statement of Additional Information (SAI), also known as Part B. The SAI includes the fund’s financial statements, information about the fund’s historical performance and policies, details on the fund’s managers and directors, brokerage commissions etc., thus providing valuable information on the fund’s operations in greater detail than the main prospectus.

Finally, there is no single mutual fund prospectus that does not warn investors that the past performance of a mutual fund does not guarantee its future performance. Scientific evidence has shown that mutual funds that have outperformed the market in the past are as likely to underperform it in the future as they are to outperform it. This is particularly valid for aggressive funds and growth funds because they are more volatile and in order to maintain their growth they need to be more actively managed, thus being more exposed to the risk of mistakes in stock selection and the fees associated to active management. In any case though, a mutual fund’s past performance in no guarantee for its future performance.