The prospectus is the single most important document produced by the mutual fund, and it is a must-read for investors before investing. Current shareholders must be sent new prospectuses when they are updated, at least once every 14 months.
The prospectus is generally organized into sections, and it must cover specific topics. The front usually gives a quick synopsis of the fund: investment category, sales or redemption charges, minimum investment, retirement plans available, and address and telephone number. More detailed descriptions are in the body of the prospectus.
Fee Table
All mutual fund prospectuses must include a table near the front that delineates all fees and charges to the investor. The table contains three sections: The first section lists shareholder fees, including all front-end and back-end loads and redemption fees; the second section lists all annual fund operating expenses, including management fees and any 12b-1 charges, as a percentage of net assets; and the third section is an illustration of the total cost of these fees and charges to an investor over time. The illustration assumes an initial investment of $10,000 and a 5% growth rate for the fund, and states the total dollar cost to an investor if shares were redeemed at the end of one year, three years, five years, and 10 years.
Financial Highlights
One of the most important sections of the prospectus contains the financial highlights, which provide statistics on income and capital changes per share of the fund. The per share figures are given for the life of the fund or five years, whichever is less. Also included are important statistical summaries of investment activities throughout each period. These financial statements are also contained in the annual report.
This section summarizes the financial activity over the fund's fiscal year, which may or may not correspond to the calendar year, to arrive at the ending net asset value for the fund. The financial activity summarized includes increases in net asset value due to dividend and interest payments received and capital gains from investment activity. Decreases in net asset value are due to capital losses from investment activity, investment expenses, and payouts to fund shareholders in the form of distributions.
Potential investors may want to note the line items in this section.
Net investment income represents the dividends and interest earned by the fund during its fiscal year less expenses. Expenses reflect such fund costs as the management fee, legal fees, and transfer agent fees. These expenses are given in detail in the statement of operations section of the annual report. Net investment income is important for investors to note because it reflects the level and stability of net income over the time period. A high net investment income would most likely be found in funds that have income, rather than growth, as their investment category. Since net investment income must be distributed to shareholders to avoid direct taxation of the fund, a high net investment income has the potential of translating into a high tax liability for the investor.
Net realized and unrealized gain (loss) on investments is the change in the value of investments that have been sold (realized) during the period or that continue to be held (unrealized) by the fund.
Distributions to fund shareholders are also detailed. These distributions will include dividends from net investment income for the current fiscal period. Tax law requires that income earned must be distributed in the calendar year earned. Also included in distributions will be any realized net capital gains.
The net asset value at the end of the period reflects the value of one share of the fund. It is calculated by determining the total assets of the fund and dividing by the number of mutual fund shares outstanding. The figure will change for a variety of reasons, including changes in investment income, expenses, gains, losses, and distributions. Depending upon the source of change, a decline in net asset value may or may not be due to poor performance. For instance, a decline in net asset value may be due to a distribution of net realized gains on securities.
The financial ratios at the bottom of the financial highlights table are important indicators of fund performance and strategy. The expense ratio (ratio of total expenses to average net assets) relates expenses incurred by the fund to average net assets. These expenses include the investment advisory fee, legal and accounting fees, and 12b-1 charges to the fund; they do not include fund brokerage costs, loads, or redemption fees. A high expense ratio is difficult for a fund manager to overcome and detracts from your investment return. In general, common stock funds have higher expense ratios than bond funds, and smaller funds have higher expense ratios than larger funds. International funds also tend to have higher expense ratios than domestic funds. Index funds usually have the lowest expense ratios. The average expense ratio for common stock funds is 1.2%, international stock funds 1.2%, index stock funds 0.8%, and bond funds (taxable and non-taxable) about 0.6%.
The ratio of net investment income to average net assets is very similar to a dividend or bond yield. This, too, should reflect the investment category of the fund. Common stock funds with income as a significant part of their investment objective, such as growth and income funds, would be expected to have the highest ratios and aggressive growth funds would normally have ratios close to 0%. Bond funds would normally have the highest ratios of all funds.
The portfolio turnover rate is the lower of purchases or sales divided by average net assets. It reflects how frequently securities are bought and sold by the fund. For purposes of determining the turnover rate for common stock funds, fixed-income securities with a maturity of less than a year are excluded, as are all government securities, short and long term. For bond funds, however, long-term U.S. government bonds are included.
Investors should take note of the portfolio turnover rate, because the higher the turnover, the greater the brokerage costs incurred by the fund. Brokerage costs are not reflected in the expense ratio but instead are directly reflected as a decrease in net asset value. In addition, mutual funds with high turnover rates generally have higher capital gains distributions—a potential tax liability. Small-cap growth stock funds are most likely to have high turnover rates. Some bond funds may also have very high portfolio turnover rates. A 100% portfolio turnover rate indicates that the value of the portfolio was completely turned over in a year; a 200% portfolio turnover indicates that the value of the portfolio was completely turned over twice in a year. The portfolio turnover rate for the average mutual fund is around 100% but varies with market conditions and investment category.
Investment Objective/Policy
The investment objective section of the prospectus describes the types of investments the fund will make—whether it is bonds, stocks, convertible securities, options, etc.—along with some general guidelines as to the proportions these securities will represent in the fund's portfolio. The investment objective statement usually indicates whether it will be oriented toward capital gains or income. In this section, the management will also briefly discuss its approach to market timing, risk assumption, and the anticipated level of portfolio turnover. Some prospectuses may indicate any investment restrictions they have placed on the fund, such as purchasing securities on margin, selling short, concentrating in firms or industries, trading foreign securities, and lending securities; this section may also state the allowable proportions in certain investment categories. The restrictions section is usually given in more detail in the statement of additional information.
Fund Management
The fund management section names the investment adviser and gives the advisory fee schedule. Most advisers charge a management fee on a sliding scale that decreases as assets under management increase. Occasionally, some portion of the fund adviser's fees is subject to the fund's performance relative to the market.
Some prospectuses will describe the fund's officers and directors with a short biography of affiliations and relevant experience. For most funds, however, this information is provided in more detail in the statement of additional information. The fund shareholders elect the board of directors; the board of directors selects the fund adviser. The adviser is usually a firm operated by or affiliated with officers of the fund. Information on fund officers and directors is not critical to fund selection. The prospectus also names the portfolio manager of the fund. The portfolio manager is responsible for the day-to-day investment decisions of the fund and is employed by the fund adviser. Who the portfolio manager is and how long the manager has been in the position can be useful in judging historical performance.
Other Important Sections
There are several other sections in a mutual fund prospectus of which investors should be aware. They will appear under various headings, depending upon the prospectus, but they are not difficult to find.
Mutual funds that have 12b-1 plans must describe them in the prospectus. A description of these plans must be prominently and clearly placed in the prospectus, usually in a section titled "Distribution Plan." The distribution plan details the marketing aspects of the fund and how they relate to fund expenses. For instance, advertising, distribution of fund literature, and any arrangements with brokers would be included in the marketing plan; the 12b-1 plan pays for these distribution expenses. The distribution plan section specifies the maximum annual 12b-1 fee that can be charged. Funds often charge less than the maximum. The actual charge to the fund of a 12b-1 plan is listed at the front of the prospectus in the fee table.
The capital stock section, or fund share characteristics section, provides shareholders with a summary of their voting rights, participation in dividends and distributions, and the number of authorized and issued shares of the fund. Often, a separate section will discuss the tax treatment that will apply to fund distributions, which may include dividends, interest, and capital gains.
The how-to-buy-shares section gives the minimum initial investment and any subsequent minimums; it will also list load charges or fees. In addition, information on mail, wire, and telephone purchases is provided, along with distribution reinvestment options, automatic exchange, investment and withdrawal plans, and retirement options.
The how-to-redeem-shares section discusses telephone, written, and wire redemption options, including automatic withdrawal plans, with a special section on signature guarantees and other documents that may be needed. Also detailed are any fees for reinvestment or redemption. Shareholder services are usually outlined here, with emphasis on exchanges among funds in a family of funds. This will include any fees for exchanging, any limits on the number of exchanges allowed, and any other exchange restrictions.
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