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Prospectuses, Annual Reports, and Other Documents

By: , dated January 25th, 2013

Every mutual fund is required to publish documents that help you evaluate its suitability as an investment. There are three such documents that are especially important, and which you should read and understand before making the decision to invest in any given mutual fund: the prospectus, the Statement of Additional Information (SAI) and the annual report. Although these documents are usually rife with legal and financial jargon, they also contain important information about the fund and its overall financial health. Each is described below.

Prospectus

The first place you should look for information when considering investing in a mutual fund is the fund’s prospectus. The prospectus is a legal document required by the Securities Act of 1933 that explains the mutual fund offer. It includes information about the terms of the offer, the issuer, and its objectives. Before you invest in a mutual fund, you should always make sure that you understand what it said in the prospectus. Prospectuses can seem daunting at first as they are packed with information and tables, but you should keep in mind that the information presented there is for your benefit. When reading through a prospectus you should look for the following key sections:

Investment Objective

At the front of the prospectus should be a short statement of the fund’s investment objectives. This section contains information about what the fund hopes to accomplish — for example, some funds might aim to achieve short-term growth while others might focus on long-term stability. You should check to see whether or not the fund’s objectives match your own personal investment objectives, since you probably only want to invest in funds that have similar goals to your own. Be careful when evaluating a fund’s investment objective, however, since they are often times vague. It’s always a good idea to look through the rest of the prospectus to get a better sense of the fund before making any decisions about whether or not to invest.

Investment Strategy

While the investment objectives section outlines what goals the fund hopes to accomplish, the investment strategy section describes exactly how the fund plans to accomplish them. For example, a mutual fund whose objective is current income might adopt a strategy involving a mixture of bonds and other fixed income securities. The prospectus does not, however, include a list of specific stocks or bonds in which the fund invests — it simply describes the types of assets which the fund purchases (e.g. corporate bonds or small cap stocks). But the prospectus usually does detail its asset allocation plan, and some may even specify maximum or minimum percentage limitations for specific asset classes.

Fees and Expenses

Although mutual funds aim to make money for their investors, their ultimate goal, just like any other business, is to make money for themselves. In order to do so, funds charge their shareholders a variety of fees and expenses, all of which must be documented in the prospectus. A table at the front of every prospectus contains a breakdown of the different fees and expenses, along with a hypothetical projection of how the fees would impact a $10,000 investment over a 10 year period. This should make it easy for you to compare fees and expenses across mutual funds .

Account Information

This section contains very basic information about how to buy and sell shares and other account-related information. For most mutual funds the method of buying shares is the same. You can either go the traditional route and send a check to the fund each time you want to deposit more money, or you can set up automatic withdrawals from your bank account. Some mutual funds also allow wire transfers for quick deposits, but often times they charge a small fee for the transfer.

In addition to telling you how to get your money into the fund, the prospectus will also tell you how to remove it. Most mutual funds will require that you fill out a redemption form or write a letter to the fund in order to receive your investment. However, some funds will also let you redeem shares over the phone and others will even wire the money straight into your bank account for you (although usually they will charge a fee for this service). The prospectus will inform you which of these redemption methods are available to you.

Risks

One of the most important sections in the prospectus is the one describing the level of risk that the fund takes with its investments. Although all investments in stocks and bonds (with perhaps the exception of U.S. Treasuries) involve some measure of risk, this section will tell you what risks are associated with the specific investments made by the fund. So, for example, if the fund invests in emerging markets, this section would include information about the risks particular to investing in such markets (e.g. political, economic and/or social instability).

Performance

This section is usually entitled “Financial Highlights” or “Per Share Data Table.” It includes information about the fund’s performance over the last 10 years (or less, if it hasn’t been around that long.) When looking at the fund’s historical performance, however, it’s important for you to remember that past performance is not necessarily an indicator of future results. Still, you can judge how well the fund has traditionally performed compared to an index, such as the S&P 500. You can also get some useful information from this section about the fund’s volatility, dividend payments, and turnover .

Management

This is the section where you’ll have the opportunity to find out more about the people in charge of your money. The management section should tell you the name of your manager along with some additional information about his or her experience and qualifications (if this information is missing, you should consult the Statement of Additional Information, the annual report, or the company’s web site). Once you know your portfolio manager’s name, you can try to find out whether or not he or she has managed other funds in the past in order to get a sense of his or her past strategies and results.

Statement of Additional Information

In 1983, the Securities and Exchange Commission began to require that mutual funds split their prospectuses into two parts — the “prospectus” (described above) and the Statement of Additional Information (SAI). While the prospectus contains a simple summary of the fund and its objectives, the SAI contains much more detailed information about the fund. It’s important for you to understand that the SAI is considered to be part of the prospectus, so for legal purposes it is assumed that you have read it. But whereas mutual funds routinely send out prospectuses and annual reports to potential investors, they don’t always send out the SAI unless it is specifically requested. If you don’t receive the SAI with the prospectus, you should request one before making an investment decision.

The SAI goes into great detail about the fund’s board of directors, and you might be interested in knowing just how much you, as a shareholder, are paying them. On a more practical level, though, the SAI can tell you much more about any limitations on the fund’s investments (e.g. if it is restricted from purchasing certain assets), and it will break down in detail the fees and expenses that are mentioned in the prospectus. Although the SAI may look like a long and tedious document, it in fact contains a wealth of valuable information.

Annual Report

Every year (or, in some case, twice a year) your mutual fund will send you a report describing the fund’s performance for the previous year. You should use these annual reports to check whether or not your fund is performing according to your expectations. The reports include a list of the fund’s financial statements, a list of the fund’s securities, and explanations from the fund’s management as to why the fund performed as it did. There is also usually a line graph comparing the fund’s performance to a benchmark, such as the S&P 500.When looking a fund’s annual report, you should ask yourself the following questions:

    • Is the fund comparing itself to an appropriate benchmark? It would make little sense for a technology fund to compare itself to the Dow, since only a handful of Dow components are in the tech sector. Make sure the report is using a reasonable benchmark to assess its performance.
    • How did the fund perform in its peer group? There are probably dozens of funds that are similar in objective to the one you own. You should check to see whether or not your fund managed to beat its peers (you can find out how other funds performed by requesting copies of their annual reports or by searching on the internet for performance information.
    • What does the manager have to say about the fund’s performance? Obviously, the manager is always going to try to put a positive spin on why the fund performed the way it did. You should read his or her statement carefully to determine if the manager really knows what he or she is talking about.
    • What are the fund’s fundamentals? You can look through the financial statements to find more information about the fund’s Net Asset Value, its turnover ratio, and its expense ratio. Make sure these are in line with what you expect from a fund.
    • And finally, what securities does the fund hold? Although one of the big advantages to investing in securities 
    • via mutual funds is having a professional manage your investments for you, nevertheless it’s a good idea to know what specific securities are being chosen. You may even want to consider doing your own research on the top holdings.
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