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Updated April 23, 2024 Reviewed by Reviewed by JeFreda R. BrownDr. JeFreda R. Brown is a financial consultant, Certified Financial Education Instructor, and researcher who has assisted thousands of clients over a more than two-decade career. She is the CEO of Xaris Financial Enterprises and a course facilitator for Cornell University.
Part of the Series Mutual Funds: Different Types and How They Are PricedMutual Funds Basics
Types of Mutual Funds
Mutual Fund Costs
As a mutual fund investor, you've probably heard more than once that you should always consult a mutual fund prospectus before handing over your money. However, the terminology in one can be difficult for some. It's no secret that the size of this document and the type of information inside can be hard to tackle. Here is a guide to what a prospectus is, why it is important, and what's central for you to review.
A mutual fund prospectus details the investment objectives and strategies of a particular fund or group of funds, as well as the finer points of the fund's past performance, managers, and financial information. You can obtain these documents directly from fund companies through mail, email, or phone. You can also get them from a financial planner or advisor. Fund companies also provide PDF versions of their prospectuses on their websites. Finally, you can also find them on the SEC's website.
A prospectus is a legally binding contract between the fund and the fundholder. It's easy to get lost in all the legal jargon and miss the information that matters most to you, so we're sharing an outline of sections to which special attention should be paid. Note that the way a fund's prospectus is organized may vary. However, by law, all prospectuses must contain the following important sections:
These are the fund's financial goals, which are reflected in the types of securities chosen to achieve those goals. Types of investment objectives include long-term capital growth, stable income, high total return, etc. Fund companies can't change these unless fund investors consent to the changes through a vote.
Determining whether the fund's goals match your investment goals is important. For example, a fund with an above-average capital growth objective would probably not be a good fit for a retiree who needs regular income from investments to cover day-to-day expenses.
This part of the prospectus explains how a fund allocates and manages its resources to achieve its investment objectives. The strategy includes setting goals for net asset value, determining asset allocation, investment restrictions (such as only investing in certain industries), and deciding whether (and how) derivatives may be used.
A fund's investment strategy, like its goals, should align with your investment style. For example, although a small-cap fund and a large-cap equity fund both aim for long-term capital appreciation, they use very different strategies to achieve this goal. Before choosing one type of fund over another, consider why investing in any one of these asset types is right for you. Otherwise, you might be in for some surprises.
Because investors have varying degrees of risk tolerance, the risk section of a prospectus is essential. It details the risks associated with a particular fund, such as credit, interest rate, and market risks.
To get the most out of this section, you should be familiar with what distinguishes the different kinds of risk, why they are associated with particular funds, and how they fit into the balance of risk in your overall portfolio. For example, if a fund invests a large portion of its assets in foreign securities, you need to know that this may pose significant foreign exchange and country risks. You must also determine whether this kind of risk works with other types in your portfolio.
This section shows the fund's track record, but remember the standard disclaimer that "past performance is not an indication of future performance.” Read the historical performance of the fund critically and make sure to take into account both long- and short-term performance. Also, check to see if the benchmark chosen by the fund is appropriate. For example, using the performance of federal Treasury bills as a benchmark for an equity fund is useless—the S&P 500 is generally the accepted benchmark for equities. In addition, keep in mind that many of the returns presented in historical data don't account for tax, or some funds calculate an after-tax return with a rate that may be higher or lower than your own. Be sure to look at any fine print in these sections, as they should say whether taxes have been taken into account.
A fund pays its investors income from realized capital gains, dividends, interest, and other sources in its portfolio of securities. The distribution policy tells you how these payments are made. Some funds distribute returns directly to unit holders, while others reinvest the distributions into the fund, buying more units for fundholders. It also tells you how often distributions occur.
Whether these distributions are paid in cash or reinvested, unit holders must pay taxes on them. If you are concerned about taxes, there are tax-managed funds that limit income and capital gain distributions. These tax-managed funds help ensure that you maximize your tax-shelter options, such as your 401(k) or individual retirement account.
This section is extremely important to consider because fees and expenses will eat into your total investment return from the fund. Here, you will find information on any back- or front-end loads, 12B-1 fees, and the management expense ratio. These affect your return regardless of the fund's performance.
Here, you'll find details on how long your fund manager has managed your fund. Watch out for whether the fund has been in operation significantly longer than the fund manager has been managing it. The performance might be due to the previous fund advisor, not the current one. If the newer manager has been operating the fund for only a short period, look into past performance with other funds with similar investment goals and strategies.
Information on the fund managers' experience, tenure, and past performance offers insights into their expertise and strategy, influencing an investor's confidence in the fund's management.
Start by focusing on sections detailing the fund's objectives, strategies, risks, and fees. Using the glossary and relevant Investopedia articles to understand specific terms will make the document more manageable.
While past performance data offers insights into the fund's historical achievements, it certainly does not guarantee future results due to the unpredictable nature of financial markets and changing economic conditions. The circumstances that meant the fund was successful in the past might not repeat themselves in the future.
After reading the prospectus sections outlined above, you will have a good idea of how the fund works and what risks it may pose. Most importantly, you can determine whether it is right for you. If you need more information beyond what the prospectus provides, you can consult the fund's annual report, which is available directly from the fund company or through a financial professional.
