Photo by Markus Spiske on Unsplash
You have seen it in the footnotes of any marketing materials: “Please read the prospectus carefully before investing.” Going through one is not very enjoyable given the legalese in which they are written. However, there is quite a bit of useful information, so if you have never read one, I suggest you do. It can help you discern whether a fund is active or passive, gives you estimates of the cost of investing, and help you decide whether the fund should be in your portfolio, or at least weed out funds that should not be.
Reading a few prospectuses will also help you decide if you want to go ahead and invest on your own or with the help of an advisor. If you already have an advisor, it never hurts to learn more and ask a few questions. A good advisor will be happy to share their knowledge with you. So, here is a roadmap and some tips to help you go through one.
Investment Objective
Prospectuses start with an objectives section, which usually contains relatively simple and sometimes vague statements about the overall goal of the fund. It includes statements like: the objective of the fund is long term appreciation or growth, or to provide returns in line with a selected investment universe (like emerging markets, US government bonds, etc.), or that the objective is to track a particular index. Not a lot of insight here but it can help you eliminate a fund with an explicit objective that does not fit your investment plan. If an index is mentioned, you may want to research the index to learn what investments it includes. Index factsheets are readily available online.
Fees
This is one of the most important aspects to consider. Fees are one of the best predictors of future performance, and the direction of the prediction is not what you might expect: Higher fees are usually associated with lower returns. We suggest staying away from funds that charge total fees above 0.65%. Prospectuses report management fees, distribution and marketing fees (called 12b-1 fees) and other expenses (costs for the general administration and maintenance of a fund). The total is what you pay, and different funds families may use different names for it. Most commonly, you’ll see total annual operating expenses or net expense ratio to investors, or similar.
Because these percentages can be confusing, prospectuses report the costs in a standardized way. For example, assume a fund reports a net expense ratio to investors of 0.28%. This means that if you invest $10,000, and in the first year the fund grows by 5%, the fee you pay will be about $29 (10,000*1.05*0.28%). The fee table usually shows you your total cost over 1, 3, 5, and 10 years. The point here is that the fee will grow proportionately with your investments. If you are considering a high fee fund, think about over 10 years what you may have to pay given the potential size of your investment.
Turnover
The turnover is a measure of trading activity, which tells you something about the cost of ownership of a fund, and its investment philosophy. For example, a turnover of 50% means that half of the investments in a fund are replaced every year. When a fund trades, it incurs costs to do so, and may trigger short-term and long-term capital gains, which are taxable to investors. Trading costs are not included in the fees you pay for the fund, but will be reflected in the performance of the fund over time as a drag on returns.
Stock funds that passively track a value-weighted index with a large number of investments have very low turnover, from less than 5% for US total market indices, to over 30% for some more specialized indices (e.g. small value). If turnover is much higher, either the fund is active, or it covers a narrow investment selection. You may be better off avoiding expensive, actively managed funds as they have unreliable track records. And in general, a high turnover means that the fund is more likely to realize capital gains, which are distributed to investors, making the fund inefficient from a tax perspective. It is not unusual for actively managed funds to have a turnover greater than 70% or well above 100% for more specialized funds.
Turnover is less meaningful a measure for bond funds, particularly for short term funds, since bonds that mature will have to be replaced in the fund. For example you would expect a turnover of 50% in a bond fund that holds 2-year bonds. However, it is still a good idea to compare turnover among similar bond funds.
Principal Investment Strategies and Principal Risks
This is where you find the most information about what type of investment strategies the fund pursues. Index funds will state the index they are tracking. That’s useful information because you can use it to research the index or check that it represents the market segment (asset class) you are interested in. We discussed some common indices in a previous post. Other funds may mention an index to define the general universe of stocks or bonds they pick from in their strategy.
For stocks funds, in this section you can learn if the fund invests in domestic or international companies (or both), and get some idea of the strategy they follow. They may be focused on strategies like growth, value, midcap, blue chip, sector selection, and hundreds more. Often the fund manager describes how they select companies to invest in. That may be useful, but don’t expect a lot of details.
For bond strategies, this section can include information about the duration or maturity target of the bonds that will be in the fund (often expressed relative to an index), whether it invests in domestic or international issuers, the credit rating of the bond that is allowed, the use of financial instruments like options and futures, and whether borrowing or leverage is allowed. Similar to equity funds, actively traded bond funds also describe how they choose individual bonds to include in the fund.
The “principal risks” section is related to the strategies section and broadly explains the potential risks that you face. It doesn’t provide much information but may help clarify the strategies involved.
Information asymmetry
You can’t expect fund companies to explain every detail of how they manage a portfolio. Fund management is a very competitive business and managers are reluctant to reveal their proprietary methods. Good fund management should also be somewhat flexible, and too many stated details of what the manager is going to do may overly constrain the manager while pursuing investors’ best interest. So you can’t expect the prospectus to be a complete representation of a strategy. If you think you need more information, you can read the annual or semiannual reports of the funds. These will include the actual investments of the funds.
However, if you are not satisfied with what you are reading, you may decide to seek help from an expert, or give up on a particular fund. Often, investors rely on the reputation of the manager, or some external rating. But that’s no guarantee that the fund will be right for you.
Performance
The last section in a prospectus is the performance of the fund. This section is included to give you a general idea of how the portfolio performs over recent time periods, and on average over standardized periods, like 1 year, 5, years, 10 years, and since inception.
Every fund will print this in the performance section: “past performance is not an indication of future performance.” The main reason is that a large element of a fund’s performance is outside the control of its managers, and research bears it out. The performance section is still useful. The year-by-year returns can be used to assess whether the performance was in line with the stated objective and strategies of the fund, and the level of risk that can be expected.
The performance section also includes the performance of the fund’s benchmark index. That is the performance that the fund compares itself to. In the case of an active fund, the active fund’s objective is to beat the index with higher returns. Index funds on the other hand seek to replicate the fund’s performance as close as possible. However, index funds incur operating costs that indexes do not. So you should expect a difference in returns equal to the net expense ratio to investors (if an index returns 5% and the index fund charges 0.1%, a good tracking performance means the returns of the fund should be close to 4.9%). Index funds differ in their ability to track indices, particularly in international markets.
Investing is a long term endeavour, both because the horizon of your goals is long, and because it may take a long time for an investment strategy to perform as designed. The amount of research and care you put in selecting your investments should reflect that. Reviewing the prospectus can be an important step in investment selection. It will not answer all your questions, but it may help you learn what you don’t know. You may then decide to do more research to learn more, or seek the help of a professional. In the latter case, you now know what questions to ask.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
