I f you've never seen a mutual fund prospectus, sift through the unopened mountain of mail from fund companies looming over Philip Bregstone's desk. You'll find one or two there, but better hurry. The pile is getting bigger and the Lafayette, Colo., resident says he's going to toss it into the recycling bin any day now.

Bregstone, a music teacher and owner of a window-cleaning service, rarely looks at a prospectus before purchasing shares in a fund, a habit shared by more than half of the investors the Investment Company Institute, Washington, D.C., surveyed in 1997. In fact, the trade organization found that most survey respondents were well-informed, but preferred consulting professional advisers and financial newspapers or magazines to digging through the arcane legalese that's been the language of most prospectuses. Nevertheless, the standard advice to mutual fund investors is always read the prospectus.

If you can survive the document's technical jargon, you actually will unearth valuable information about a fund's fees, objectives, strategies, risks, and performance. And it's not as if prospectuses are hard to find. Mutual funds must provide them free to all prospective purchasers, and most can be downloaded through the U.S. Securities and Exchange Commission's (SEC) EDGAR archive, as well as from hundreds of fund-company Web sites.

Moreover, prospectuses have become a tad more consumer-friendly since an SEC rule went into effect last October requiring funds to write key sections in "plain English." At the same time, the SEC granted fund companies the right to issue profile, or summary, prospectuses.

It's likely that many funds will opt to send investors the slimmer, more economical profile, says John Markese, president of the American Association of Independent Investors (AAII), Chicago. But Markese cautions against using a profile as your sole resource. "Look through a profile, and if you're interested, go on to the full prospectus."

Despite the plain English regulation, a prospectus is not a light read. But focusing on the following sections can help you make informed decisions.
    A fund manager's
    must match
    your own
    investing goals.

High expense ratios
will erode
your investment's
net return.
Objectives and strategies
A fund's portfolio mix and investment strategies should match your own investment goals. To ensure that it does, read about the fund's specific objective briefly described on the prospectus cover page and further defined in the investment objective section. Here you'll learn whether the fund is more oriented toward capital growth or income (dividend distribution).

The strategy section describes the fund's investment focus (stocks, bonds, options) and what percentage of the portfolio each type of security represents. You'll also learn whether it targets a particular industry sector (technology, health), stock classification (small- or large-cap), or market (domestic or international).

Note whether the offering is a diversified or nondiversified fund. Diversified offerings may invest only 5% of assets in a single security, while nondiversified funds may invest as much as half of all assets in any one security.

If you don't understand this section or require more information, obtain a copy of the statement of additional information (SAI) through the fund company or the SEC's database. The prospectus actually is a summary of the SAI, which goes into far greater detail about the fund's characteristics.

Fees and operating expenses
From sales loads to marketing fees, mutual funds can assess a variety of charges affecting your investment return over the long haul. The shareholder pays some charges directly and others are deducted from fund assets. Prospectuses describe fees in a standardized table that's divided into three sections:

1. Shareholder fees are direct fees that may include sales charges (loads) for purchases and reinvested dividends; deferred sales charges; redemption fees; fees for exchanging shares within a family of funds; and annual maintenance fees for accounts that fall below a minimum balance. Investors pay additional transaction fees for wire transfers, returned checks, and stopped payments.

2. Annual operating expenses are indirect charges that may include management fees; investment advisory charges; and annual 12b-1 distribution fees, which cover such costs as sales commissions and marketing expenses.

3. The expense projection illustrates how much the fund would cost if you invested $1,000 and then redeemed all shares at the end of one, three, five, or 10 years. The calculation assumes a 5% return for each year and that the fund's operating expense remains the same throughout each year. Remember: This is a hypothetical example that uses a standard formula. It in no way reflects how much these expenses will affect your actual net return.

It may seem logical to stick with no-load funds, but a low-load fund with low annual expenses could cost less, even over the short term, than a no-load fund with high annual expenses and annual 12b-1 fees.

Again, keep your investment goals in mind when analyzing fees and expenses. The SEC's new mutual fund cost calculator will help you determine which type of cost structure is appropriate for your situation.

Don't forget
to check out
current data
annual reports
and third-party
rating services.
Financial highlights
Every prospectus publishes a standard table of ratios and data that summarizes its financial performance over several years. The table shows the net asset value (NAV) per share at both the beginning and end of each year, and the fund's total return. To gauge a fund's current and historical performance, be sure to look at its current annual report and check out charts available through a third-party rating service such as Morningstar or ValueLine. Here are a few of the table's line items and how each could affect your choice of funds:

Net investment income represents investment income (dividends and interest) less expenses. Income-oriented funds are more likely than growth funds to have high net investment income. Because companies distribute net investment income to shareholders to avoid direct taxation of the mutual fund, a high ratio here may mean a possible tax liability for the individual investor.

NAV is the value of one share of the fund. This figure fluctuates from year to year depending on a variety of factors. Because fund distributions often account for NAV changes, a decline does not necessarily indicate poor performance. A fund's annual report will elaborate on the ups and downs of particular years.

The expense ratio affects the fund's NAV. It includes operating costs—the investment advisory fee, fund administrative expenses, and 12b-1 fee. The relative size of this number will vary depending on the type of fund. For example, a common stock fund typically has a higher expense ratio than a bond fund (see table below). Although you shouldn't buy a fund solely on the basis of this number, be aware of how the fund's expense ratio compares with that of similar funds. If it strikes you as being excessively high, this could be a red flag that warrants further investigation.

Fund Category Average Expense Ratio
Domestic stock funds 1.1%
International stock funds 1.4   
Domestic bond funds 0.7   
International bond funds 1.2   
Index funds 0.4%
Source: AAII

The portfolio turnover rate is expressed as a percentage. A 100% turnover rate means that all securities in the portfolio were turned over in a year. Why should the turnover rate concern you? Because sales of securities incur brokerage fees, which decrease the fund's NAV. In addition, investors may face potential tax liabilities if the fund has a high capital gains distribution—a common characteristic of funds with high turnover rates.

Additional information
The prospectus contains a few other sections that you shouldn't overlook, including:
  • Fund management data. This section explains who the investment adviser is—typically a firm affiliated with the officers of the fund—and the fund's advisory fee schedule. It also names the portfolio manager or, more often, the team managing the fund.

  • Distribution plan. Mutual funds that charge an annual 12b-1 fee must include a section describing the plan and note the maximum fee it can charge.

  • Fund share characteristics. This provides a description of shareholder voting rights, information about dividends and distributions, and the number of shares the fund has issued.

  • Share purchase. The fund outlines its minimum purchase requirements, sales loads, fees, and information about how to purchase shares, reinvestment options, investment and withdrawal plans, and other programs.

  • Share redemption. This section provides information about exchanging shares within a family of funds and describes how to redeem shares, the documents necessary for redemption, and the fees for reinvestment or redemption.
Be prepared to spend a good deal of time with a prospectus, particularly if proceeds from mutual funds are going to supplement your retirement years. Obviously, a prospectus is not a crystal ball. But understanding how to read key data and statistics can only help you better locate those potential gold mines.

©1999 Credit Union National Association Inc.