Subject: Mutual Funds - Reading a Prospectus
Last-Revised: 9 Aug 1999
Contributed-By: Chris Stallman (chris at teenanalyst.com)
Ok, so you just went to a mutual fund family's (e.g., Fidelity) web site and requested your first prospectus. As you anxiously wait for it to arrive in the mail, you start to wonder what information will be in it and how you'll manage to understand it. Understanding a prospectus is crucial to investing in a mutual fund once you know a few key points.
When you request information on a mutual fund, they usually send you a letter mentioning how great the fund is, the necessary forms you will have to fill out to invest in the fund, and a prospectus. You can usually just throw away the letter because it is often more of an advertisement than anything else. But you should definitely read the prospectus because it has all the information you need about the mutual fund.
The prospectus is usually broken up into different sections so we'll go over what each section's purpose is and what you should look for in it.
- Objective Statement
Usually near the front of a prospectus is a small summary or statement
The objective statement is really important in choosing your fund. When you choose a fund, it is important to choose one based on your investment objective and risk tolerance. The objective statement should agree with how you want your money managed because, after all, it is your money. For example, if you wanted to reduce your exposure to risk and invest for the long-term, you wouldn't want to put your money in a fund that invests in technology stocks or other risky stocks.
The performance section usually gives you information on how the mutual fund has performed. There is often a table that gives you the fund's performance over the last year, three years, five years, and sometimes ten years.
The fund's performance usually helps you see how the fund might perform but you should not use this to decide if you are going to invest in it or not. Funds that do well one year don't always do well the next.
It's often wise to compare the fund's performance with that of the index. If a fund consistently under performs the index by 5% or more, it may not be a fund that you want to invest in for the long-term because that difference can mean the difference of retiring with $200,000 and retiring with $1.5 million.
Usually in the performance section, there is a small part where they show how a $10,000 investment would perform over time. This helps give you an idea of how your money would do if you invested in it but this number generally doesn't include taxes and inflation so your portfolio would probably not return as much as the prospectus says.
- Fees and Expenses
Like most things in life, a mutual fund doesn't operate for free. It costs a mutual fund family a lot of money to manage everyone's money so they put in some little fees that the investors pay in order to make up for the fund's expenses.
One fee that you will come across is a management fee, which all funds charge. Mutual funds charge this fee so that the fund can be run. The money collected from the shareholders from this fee is used to pay for the expenses incurred from buying and selling large amounts of shares in stocks. This fee usually ranges from about 0.5% up to over 2%.
Another fee that you're likely to encounter is a 12b-1 fee. The money collected from charging this fee is usually used for marketing and advertising the fund. This fee usually ranges between 0.25-0.75%. However, not all funds charge a 12b-1 fee.
One fee that is a little less common but still exists in many funds is a deferred sales load. Frequent buying and selling of shares in a mutual fund costs the mutual fund money so they created a deferred sales charge to discourage this activity. This fee sometimes disappears after a certain period and can range from 0.5% up to 5%.
When you are looking through a prospectus, be sure that you look over these fees because even if a mutual fund performs well, its growth may be limited by high expenses.
- How to Purchase and Redeem Shares
This section provides information on how you can get your money into
the mutual fund and how you can sell shares when you need the money
out of the fund. These methods are usually the same in every fund.
The most common method to invest in a fund once you are in it is to simply fill out investment forms and write a check to the mutual fund family. This is probably the easiest but it often takes a few days or even a week to have the funds credited to your account.
Another method that is common is automatic withdrawals. These allow you to have a certain amount which you choose to be deducted from your bank account each month. These are excellent for getting into the habit of investing on a regular basis.
Wire transfers are also possible if you want to have your money invested quickly. However, most funds charge you a small fee for doing this and some do not allow you to wire any funds if you do not meet their minimum amount.
The fund will also provide information on how you can redeem your shares. One common way is to request a redemption by filling out a form or writing a letter to the mutual fund family. This is the most common method but it isn't the only one.
You can also request to redeem your shares by calling the mutual fund itself. This option saves you a few days but you have to make sure the fund has this option open to the shareholders.
You can also request to have your investment wired into your bank account. This is a very fast method for redeeming shares but you usually have to pay a fee for doing this. And like redeeming shares over the phone, you have to make sure the mutual fund offers this option.
Now that you understand the basics of a prospectus, you're one step closer to getting started in mutual funds. So when you finally receive the information you requested on a mutual fund, look it over carefully and make an educated decision if it is right for you.
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