understanding a fund prospectus

In short

A friend of mine once kept a fund prospectus on his shelf for three years without opening it, and I cannot say I blamed him. If you are holding one, or about to, you have probably wondered where to even begin. Start with the summary section near the front, since the rules require every fund to put the key facts there in a set order. Find the fee table first, because fees come out of your money every year whether the fund goes up or down. Next, read the objective and the main risks in plain words. Then check what the fund holds and how often it trades. None of this takes an afternoon. It takes about twenty minutes and a cup of coffee.

The whole of it

What it is

I once watched a neighbor sign a lease without reading past the rent line, and he spent a year learning what he had agreed to. A prospectus is the fund's version of that lease, only it is written to be read before you sign. It is the official document a mutual fund or exchange traded fund gives to anyone who might buy shares. Funds that sell to the public must file it with the Securities and Exchange Commission, and you can look it up for free on the commission's EDGAR database at sec.gov.

You have probably noticed that these documents look heavy. They are. But the front part is built to be short and plain, and the back part is there if you want to dig. A related paper, the Statement of Additional Information, holds the finer detail, and the fund must give it to you on request.

How it works

If you are new to this, picture the prospectus as having two layers. The top layer is the summary section. It answers six things in a fixed order: the investment goal, the fees and expenses, the principal strategies, the main risks, how the fund has performed, and who runs it. Because the order never changes, you can lay two prospectuses side by side and compare them line by line. That alone is a kindness worth appreciating.

The lower layer is the long part. It explains the strategy in more detail, describes the risks one by one, tells how to buy and sell shares, and covers taxes on payouts. Most of us read the top layer and skim the rest, and that is a fair way to start. If something in the summary puzzles you, the long part usually has the answer.

Funds also publish a shorter paper called a summary prospectus, which is just the top layer on its own. The fund may send you that and point you to the full version online.

The numbers, and where to find yours

A friend of mine says the fee table is the one page he wishes he had read at twenty. He is right to say so. Look for the line called the expense ratio. It is a yearly percent of your balance taken to run the fund. You never see a bill. The cost simply comes out of the fund's value.

Below it you may find a sales charge, called a load. A front end load is taken when you buy, and a back end load is taken when you sell. Some funds have neither. The fee table lists each one, so no hunting is needed.

You will also see an example near the table. It shows what a $10,000 investment would cost over several set time periods, assuming a set return. That example comes from rules the commission sets, so the fund must show it in the form those rules require. It gives a fair way to compare one fund with another.

Then find the portfolio turnover rate, which tells how much of the fund's holdings were swapped in a year. A high rate means more trading, and trading has costs that do not show in the expense ratio. Your own numbers live on the first few pages. If a fund tells you its expense ratio is a certain percent, check it against the fee table, because the table is the official word.

A worked example

I think of a woman I will call Denise, a nurse who had $10,000 to put aside and two funds to choose between. She was not trying to be clever. She just wanted to keep more of what she had saved. Both funds held broad groups of large company stocks. The first fund listed an expense ratio of 0.05 percent. The second listed 0.85 percent.

She did the plain math on her $10,000. At 0.05 percent, the yearly cost is $10,000 times 0.0005, which is $5. At 0.85 percent, the yearly cost is $10,000 times 0.0085, which is $85. The gap is $80 in the first year.

That looked small to her. So she stretched it out. Suppose both funds earned 6 percent a year before costs. The first fund nets 5.95 percent, and $10,000 grows at that rate for 20 years. The second nets 5.15 percent over the same stretch.

For the first fund, $10,000 times 1.0595 raised to the 20th power comes to about $31,700. For the second, $10,000 times 1.0515 raised to the 20th power comes to about $27,400. The difference is roughly $4,300, and that came from fees alone.

She did not need to guess which stocks would win. The figures she checked were printed right there in the fee table. These return numbers are only an illustration, since no one knows what a fund will earn. But the fee gap is a fact she could read on page one.

Where it goes wrong

I have watched smart people trip on the same few stones, and none of them is shameful. The first is judging a fund by last year's return. The prospectus shows past performance, but it carries a warning that past results do not predict future ones. That warning is the commission's requirement, and it means what it says.

The second is skipping the risk section because it sounds like legal talk. It is not filler. It names what could lose you money in this specific fund, such as swings in a single industry or a bet on smaller companies. Read it slowly.

The third is mixing up the expense ratio with the whole cost. A fund can carry a load, and it can carry hidden trading costs through high turnover. The expense ratio is one piece. The fee table lists the rest.

The fourth is trusting a fund's name. A fund called income or balanced or growth may hold something quite different from what you pictured. The strategy section says what it actually does.

Last, people forget about taxes. A fund that trades often can hand out taxable gains even if you never sold a share. The prospectus has a section on this. Look for it.

Questions to answer before you leave this page

Have you found the fee table, and do you know the expense ratio in plain percent and in dollars on your own balance? Can you say in one sentence what the fund is trying to do, using your own words and not the fund's? Do you know the two or three main risks the summary names, and are you comfortable living with them? Is there a sales charge when you buy or sell, and have you checked the table to be sure? Have you looked at the turnover rate, and does it fit the way you plan to hold the fund? Did you read the part about taxes on payouts? And if something still puzzles you, have you asked the fund for the Statement of Additional Information, which it must provide on request?