How to Read a Mutual Fund Prospectus

Mutual funds have two goals: to make themselves money and to make you money, usually in that order. The mutual fund prospectus gives you a chance to weigh a fund's greed against its performance so you can determine whether these guys are worth what they charge. It also gives you some fundamental parameters for comparing one fund with another. Sure, a prospectus looks daunting. It might be simpler if there were just a single line at the top with a fill-in-the-blank structure. For example, "The ____ Fund will jack you up for about ____ percent of your assets every year in expenses while growing those assets by __ percent less than the S&P 500 in an average year by investing in ____." After a little practice at reading these things, though, you should be able to fill in the blanks yourself since the prospectus actually does answer an investor's essential questions: 1. How much is the fund going to make from managing your money. 2. What kinds of returns has the fund delivered for investors in the past, and what does it generally invest in to achieve these results? The very basics are usually outlined on the cover page, though to really get a feel for the fund, you should sink your teeth into a few key sections of the prospectus. One of the major reasons that 90% of mutual funds underperform the S&P 500 index is not that the fund managers are dopes but that they charge a lot for investment advice that is literally little better than average. It's inherently more expensive to make active investment decisions than it is simply to follow a set investment menu, as the Vanguard index funds do. That's one reason that annual expenses at Vanguard's funds run around 0.31% (31 cents per $100) of assets versus 2% ($2 per $100) or more for many actively managed funds. Just to perform as well as the index fund, then, a given mutual fund might need to do 1.69% better. Annual management fees are just one of the charges an investor finds on perusing the prospectus section devoted to Transaction and Fund Expenses. The transaction side tells you about the sales charge or "load" (what it will cost you to buy into the fund), the sales charge to reinvest distributions (what it will cost to reinvest the annual profits the fund distributes to you), the redemption fees (what it will cost you to sell your shares of the fund), and the exchange fee (what it will cost you to move money from one fund to another in the same family of funds). Not all funds charge these fees, but you need to be aware that some do. The first item is the sales charge or "load" for buying into the fund. Not too long ago, mutual fund companies routinely charged you 8.5% of your initial investment just to let you in the door. Most of this amount went to pay a commission to the broker who signed you up. In the 1970s, some firms started offering no-load funds, which meant you didn't have to pay a sales charge upfront just to put your money to work. Given that no study has ever shown that load funds deliver better returns than no-load funds, Fools should assume that no-loads are the better way to go. Yet once you've dodged that bullet, you must take a closer look at the other ways the fund plans to make money from you since, after all, that's why they're in business. One possibility is some kind of a back-end load, also known as a redemption fee, or deferred sales charge. This is a charge for selling your shares in the fund. Often, the charge can run as high as 4% to 5%, but it may be reduced the longer you own the fund. Many true no-load funds have no redemption fees, and some funds have no redemption fees except for perhaps a 1% fee for investors who hold shares in the fund for less than six months or a year. These time-dependent redemption fees are designed to discourage investors from trying to time the market by jumping from one fund to another since that could leave fund managers guessing about exactly how much money they have to work with. The best no-load funds let you reinvest distributions free of charge, redeem your shares free of charge after six months or so, and shift money from one fund to another in the same fund family free of charge. Plus, if you've got more than a certain amount invested (say $2,500) or have the money in an Individual Retirement Account (IRA), the fund doesn't stick you with any "maintenance fees" just to mail you quarterly reports. So far so good, but now you must take a close look at the section on Annual Fund Expenses. If the fund isn't hitting you with transaction costs, it's got to hit you with operating expenses, and you must determine whether they look reasonable. The three ingredients in this part of the mix are the management fee, marketing or 12b-1 fee, and other expenses. Each is measured as a percentage of the fund's average net assets and are payable every year. Such recurring costs can add up to much more than even exorbitant transaction charges. The management fee is what you're paying to the folks actually making the investment decisions (and their bosses). Summer houses in the Hamptons and trips to Aspen aren't cheap, so the management fee may represent half or more of total annual expenses. Another healthy chunk will probably go to good old 12b-1, which is basically the Securities and Exchange Commission (SEC) rule that allows funds to charge you up to 1% of assets per year for the cost of marketing the fund to you and other shareholders. That's right, funds charge you for the cost of reeling you in. Revenues generated under 12b-1 may go to pay the broker who sold you on the fund or for that slick advertising on CNBC that originally caught your eye or that glossy brochure the investment company mailed you. Finally, other expenses include various administrative costs such as keeping shareholder records, sending out financial reports, filing documents with the SEC, and paying for the service department that suggests you might want to just have a smoke when the Dow is down 500 points and you're wondering if maybe your backyard might have been a better place to put your money. All of these annual expenses get tallied up as a percent of assets under management, with the handy table showing what this will cost you in real money per $1,000 over the next few years, so you can compare operating expenses at different funds. Perhaps a better comparison, though, is to remember that the Vanguard S&P 500 Index's annual expenses amount to just 0.19% of assets. When considering a new fund, it's also important to see if some of the annual fees have been temporarily reduced. That may sound good, and it is, except it may overstate the fund's current returns while setting you up to reimburse the fund company for these expenses at a later date. So far you know what the fund is going to cost you. Now you want to find out what investment strategy the fund uses. You probably already have a general sense of this because you've already done some homework before you thought about getting cozy with any prospectus. You likely determined what type of fund you were looking for (for example, growth and income, growth, or aggressive growth) and then used some kind of screening tool to find the funds in that category that have delivered the best results in the past (say, over the last year, five years, and ten years). In other words, you didn't just pick up a copy of The Brothers Karamazov Fund prospectus because it sounded like part of a heartwarming fund family. Rather, you heard that this guy Dostoevsky was a bit of genius, and you saw his fund near the top of the charts. The sections of the prospectus dealing with the fund's investment strategy and accompanying risks and the following section on the fund's management are where you go to get the skinny on who's running the fund and how they're running it. It's where you find out that this Dostoevsky fellow doesn't just invest in small-cap growth companies (say, small publishing firms), but also engages in a fair amount of gambling by trading futures and options, taking short positions, and using a fair amount of margin. Despite those great results, perhaps Dostoevsky is a bit too crazed for your liking. The prospectus won't detail actual fund holdings, but it will describe the fund's objective and the game plan for achieving it, including some definitions and limitations. For example, this section might tell you that when the fund says "small-cap," it means any company with a market capitalization below $1.5 billion. Also, it may plan to have at least 80% of assets invested in such small-caps at any given time, but it won't necessarily sell stocks that appreciate in price so that they outgrow the fund's small-cap definition. The nuts and bolts of the fund's results, though, are listed in a preceding table, usually under Financial Highlights, where you will find detailed financial information going back ten years, or as long as the fund has been in existence. Look at the section on Selected Per-Share Data. The top line lists the fund's net asset value (NAV), which is effectively the price of a fund share at the beginning of the given year, or the value of all the securities owned by the fund divided by the number of fund shares outstanding. The rest of the table indicates the net investment income (the money left from stock dividends and interest income after paying fund expenses), the net realized and unrealized gain or loss on investments (the profits on securities sold plus unrealized profits on securities currently held minus losses on securities sold and unrealized losses on current holdings), and the sum of these parts. You could just add this sum to the old NAV to get the new NAV except that mutual funds have to distribute 98% of their income and dividends each year. The less distributions section accounts for this fact. The total distributions will include net realized gains after subtracting realized losses plus the net investment income. The numbers may not jibe exactly with the above income figure because investment income may be recorded according to the fund's fiscal year, but it must be distributed based on a calendar year. The total return is simply the percent return for the given year assuming that all distributions had been reinvested. This is the number you should compare with other similar funds or with the S&P 500 for the same period. It's crucial to remember, however, that total return discounts the annual management expenses but not the transaction charges, which could still eat away at even a strong return. The next part of the table, Ratios and Supplemental Data, includes three other numbers of particular interest. First is the ratio of expenses to average net assets. These expenses include management, 12b-1, and the above other fees, but not loads or redemption fees. Though by some calculations expenses run around 1.5% at the average equity fund, you should look for funds with expenses around 1% or less. The expense ratio should also be declining over the years since as a fund's assets increase, the investment company ought to be able to squeeze out some economies of scale. The ratio of net investment income to average net assets is akin to the fund's annual dividend yield. For an income-oriented fund, one would expect a ratio around maybe 2% to 4% whereas for an aggressive growth fund, a ratio around 1% or less would be more common. Another number often underemphasized by investors is the portfolio turnover rate, which gives in percentage terms the amount of total assets that were shifted from one investment to another in the last year. A figure above 100% indicates that essentially the entire portfolio was turned over, whereas a string of years showing low turnover, say around 30%, would indicate the fund manager doesn't trade in and out of stocks but is more comfortable making long-term investments that she doesn't have to mess with for a while. Checking for a pattern in the turnover rate is important not just for what it tells you about your fund manager's investment style but for what it tells you about your likely tax hit. An investor only pays taxes on the fund's income and capital gains distributions (which usually come in December). A fund that doesn't do a lot of trading will more than likely have higher unrealized gains and thus smaller distributions. When two funds generate similar total returns, the fund investor will generally come out better with the fund experiencing low turnover because assets won't be diminished as often along the way by tax hits, and when the tax hits come, they are likely to be lower since long-term holdings will benefit from the lower capital gains tax rate. Also, more trading means higher commission costs. Though the fund pays less to trade than you do because it deals in volume, increased transaction costs from high turnover mean the fund manager has to do a little bit better just to keep up with the averages. Between expenses, returns, and investment strategy, you've pretty much milked the prospectus for most of what it's worth. A prospectus offers other information about the fund, such as how to buy and redeem shares, what your shareholder voting rights are, and other stuff that's worth knowing if you think this is the one for you. Plus, each fund also submits a Statement of Additional Information (SAI) that can be obtained by contacting the investment company or by visiting the SEC's website. The SAI goes into much greater detail about many matters found in the prospectus, particularly the tax consequences of fund distributions, but generally in a language that only a lawyer could love. If you think there's any chance you will want to sue your mutual fund company sometime down the road, be sure to read the SAI carefully since it's legally considered part of the prospectus. Writer:Louis Corrigan

How to Choose a Mutual Fund

If you are selecting actively managed mutual funds of your own volition, or if you are forced to do so because your 401(k) plan does not provide an index fund, you should have the mindset that you are selecting from a universe that underperforms the market and you are primarily attempting to cut your losses. If you think that we can give you a set of directions that are likely to beat the market using mutual funds -- well, we really don't have a system for that and we don't believe anyone else does either. But with the objective of keeping expense ratios and turnover low, you can improve your chances of finding a fund that will not lose badly to the market and improve your chances of finding a fund that holds some promise of outperforming the market. Yes, each and every year there are some mutual funds that beat the overall market, and there are even years when the majority of mutual funds beat the market. But trying to pick a mutual fund ahead of time that will beat the market is extraordinarily difficult. When "mutual fund experts" are asked to pick mutual funds that they think will beat the market, they almost always fail, typically with disastrous results. In 1998, ten mutual fund experts were asked by USA Today to pick two mutual funds for the year. None, none, were able to pick a fund that beat the market. Studies show that picking mutual funds on the basis of past performance does not work, and saints preserve anyone who picks mutual funds on the basis of screaming magazine headlines. So, can we imagine a time when a Fool would willingly choose to put his hard-earned money into a mutual fund? Imagine a Fool walking down the street, innocently minding his own business, thinking only of ways to educate, amuse, or otherwise enrich some of his fellow men. Imagine that the Fool, lost in his thoughts, doesn't notice that the street he is on is Wall Street, and that suddenly he is cornered by an extremely well-dressed gun-toting thug who starts screaming, "We measure success one actively managed mutual fund sold at a time! Pick one now, or I'll blow your head off!" Seem improbable? It should. It really should. We know Wall Street is full of a lot of irrational people, but we really don't think any of them would do this. We hope not anyway. Time will tell. But, in reality, many Fools are confronted with the necessity of picking mutual funds from of a selection in their 401(k) plans when an index fund is not one of the options. If you remember what we have described so far in the previous sections, you'll have no problem going about picking a fund. If you skipped some of those articles, fell asleep, got distracted by the television, have short-term memory problems, or just can't get enough reviews of things you've already read once, here are the salient points set forth again. Your mutual fund shopping list should read: 1. No sales charges (front loads, contingent deferred sales loads, level loads) 2. A low expense ratio (below 1.00%) 3. Low turnover, no higher than 50% a year, and preferably closer to 20% 4. Full investment policy. Cash reserves of nearly 0%. And we'll review these concepts again for ya. Studies show that over time, virtually all of the difference in return between managed funds and index funds is attributable to the higher costs imposed by actively managed funds. These costs come in the form of loads and expense ratios. You want to make sure that you are not paying any sales charges. Sales charges come in various stripes, also known as loads or commissions. There might be a charge for buying into the fund (a front-end load) or selling the fund (back-end load, deferred sales charge, or redemption fee). Avoid all of these. Some funds have back-end loads that are reduced the longer you hold the fund. Best to avoid these as well. If you have to buy an actively managed fund, buy the fund with no sales charges at all. Funds that normally have sales charges sometimes waive them or have reduced sales charges for large 401(k) accounts. Expense ratios represent the annual fees charged by all funds, including the management fee, the administrative costs, 12b-1 distribution fees, and other operating expenses. You want to make sure that the fees are as low as possible. Index funds typically charge about 0.20% of the assets, and actively managed funds currently average about 1.5% per year. The average fee, by the way, has actually been climbing in recent years. Any fund that has fees above 1% per year can be expected to underperform the total returns offered by an index fund. Turnover measures how long a fund holds on to the stocks it buys. The longer a mutual fund holds on to a stock and the less trading the fund does, the lower the turnover will be. Since a fund incurs costs every time it buys and sells stocks (just like you do), the lower the turnover, the lower the transaction costs incurred by the fund -- and the lower the capital gains taxes. Ideally, Fools like to see funds that practice the "buy and hold" method of investing -- those funds are the most index-like. Funds that have a turnover of 100% are essentially buying a completely new set of companies every year. Turnover should ideally be substantially lower than the mutual fund average of about 80%. Index funds have turnover as low as 5%. A mutual fund that has an established track record is less important than you would think. Studies show that measuring performance over two decades or longer, 99% of funds that outperform the market in one decade revert to the mean in the next decade. Past performance really isn稚 an indication of future results. If a fund has outperformed the S&P 500 recently, determine how it does against similar Morningstar style box funds. Make sure to check out the consistency of the fund's returns. You池e looking for funds that not only have shown good returns on the whole, but ones that do so on a consistent basis, rather than having great runs followed by lousy ones. Most funds that claim to have outperformed the market over a ten-year period really had most or all of their truly good performance when they were young and small. Once the fund has attracted a couple of billion extra dollars, the fund usually starts performing more in line with the market. For detailed questions about specific funds, look for help by posting your questions on The Fool's Mutual Funds and Index Funds message boards. Also visit our Index Center for detailed descriptions of some well-known indexes. Keep the fees low and select from low turnover funds and you'll generally outperform most mutual funds. An even briefer summary would be, "Just buy an index fund." Writer: Bill Barker

What is Mutual Fund

Far too often investment writers incorrectly assume that their readers understand what a mutual fund is. Read this article as an absolute starting point for learning about mutual funds. Then we can start tackling the tougher mutual fund subjects in a process that will make you a smarter investor. Getting Started Before I dive into the definition of a mutual fund, it is important that you have a basic understanding of stocks and bonds. There are certainly more variations of each than I will cover here, but I don't want to confuse you, so I will keep it simple. Stocks Stocks represent shares of ownership in a public company. Examples of public companies include IBM, Microsoft, Ford, Coca-Cola, and General Mills. Stocks are the most common ownership investment traded on the market. Bonds Bonds are basically a chance for you to lend your money to the government or a company. You can receive interest and your principle back over predetermined amounts of time. Bonds are the most common lending investment traded on the market. There are many other types of investments other than stocks and bonds (including annuities, real estate, and precious metals), but the majority of mutual funds invest in stocks and/or bonds. Mutual Funds A mutual fund is simply a financial intermediary that allows a group of investors to pool their money together with a predetermined investment objective. The mutual fund will have a fund manager who is responsible for investing the pooled money into specific securities (usually stocks or bonds). When you invest in a mutual fund, you are buying shares (or portions) of the mutual fund and become a shareholder of the fund. Mutual funds are one of the best investments ever created because they are very cost efficient and very easy to invest in (you don't have to figure out which stocks or bonds to buy). If you would like to know the history of mutual funds, click here. By pooling money together in a mutual fund, investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on their own. But the biggest advantage to mutual funds is diversification. Diversification Diversification is the idea of spreading out your money across many different types of investments. When one investment is down another might be up. Choosing to diversify your investment holdings reduces your risk tremendously. The most basic level of diversification is to buy multiple stocks rather than just one stock. Mutual funds are set up to buy many stocks (even hundreds or thousands). Beyond that, you can diversify even more by purchasing different kinds of stocks, then adding bonds, then international, and so on. It could take you weeks to buy all these investments, but if you purchased a few mutual funds you could be done in a few hours because mutual funds automatically diversify in a predetermined category of investments (i.e. - growth companies, low-grade corporate bonds, international small companies). On the next page, I clearly explain how diversification works using a "Wheel of Fortune" concept.

Cash Management

Cash is your business's lifeblood. Managed well, your company remains healthy and strong. Managed poorly, your company goes into cardiac arrest. If you haven't considered cash management an important issue, then you're probably undermining your business's short-term stability and its long-term survival. But how can you manage business cash better? Start with understanding how good cash-management practices can influence your company's growth and survival by reading "The Art of Cash Management," Inc Finance Editor Jill Andresky Fraser's classic article on the topic. Then dive into forecasting your business-cash needs and learning how to handle a cash crisis. Assembled here are practical pieces of advice, tips and tricks from CEOs, and tools that you can use to get a handle on business cash. Handling and Avoiding Crises How Do You Define Cash Flow? If your definition of cash flow is flawed, and you're not tracking the right numbers, you may grow your company right into a cash crisis. The 10 Absolutely Must Follow Cash Flow Rules Everyone wants cash on hand at all times. Here are 10 rules to help you get there. The Magic Number Every business has a magic number. By employing his, our columnist didn't overstaff this year. Riding the Economic Roller Coaster Tighten your seatbelt. Surviving the ups and downs of the world economy means keeping an eye on business finances. When a Cash Crisis Strikes Credibility with vendors, bankers, and other creditors is built slowly, but can be destroyed quickly if your company falls behind on payments. Know how to break the bad news to preserve your business's relationships. Hot Tip: Prepare for a Cash Crisis How do you prep for a cash crisis? Wayne Karpoff, president of Myrias Software Corp., knew cash would be a problem late last year. His 15-employee, $1.5-million company dropped selling its products and became a full-time service business. So he built a contingency fund into his annual budget -- an amount equal to three months' worth of payroll. He got the idea when his bank suggested he set up a contingency fund to safeguard his mortgage payments in the event he found himself out of work. He dipped into the fund three times last year to float the company during project and payment delays. Source: Ilan Mochari, Inc magazine, March 2000 Forecasting, Projections and Budgets The Secrets to Formatting Cash Flow Projections Here are the keys to creating a powerful tool to take control of your cash flow. Cash Flow Projections Made Easy Here is a 4-step process you can use to create cash flow projections you can trust. Breaking Free from Budgets Exasperated by budgets that hamstring creativity, a growing number of companies are tossing off financial constraints--and still holding the line on spending. Budgeting for Blunders Lisa Hickey created a fund to support creative risks her Boston-based ad agency, Velocity Inc., takes when trying innovative ideas that might not pan out. A Passion for Forecasting Don't put together an annual sales forecast using only gut instinct and wishful thinking! Here are some rules you can follow to create a forecast that you and your employees can count on. Action Plan: Forecasting and Cash-Flow Budgeting Developing a budget is simple, and when created with solid sales and expense forecasts in mind, you can ensure that your budget will stand up to the daily demands of your business. Here are some steps you can take to create a cash flow budget you can rely on.

RISK, THE PRICING OF CAPITAL ASSETS, AND THE EVALUATION OF INVESTMENT PORTFOLIOS (2)

The main purpose of this study is the development of a model for evalu­ating the performance of portfolios of risky assets. In evaluating the per­formance of portfolios the effects of dif­ferential risk must be taken into con­sideration.1 If investors are generally averse to risk, they will prefer (ceteris pa-Hbus) more certain income streams to less certain streams. Under these conditions investors will accept additional risk only if they are compensated for it in the form of higher expected future returns. Thus, in a world dominated by risk-averse investors, a risky portfolio must be expected to yield higher returns than a less risky portfolio, or it would not be held. The portfolio evaluation model devel­oped below incorporates these risk as­pects explicitly by utilizing and extend­ing recent theoretical results by Sharpe [52] and Lintner [37] on the pricing of capital assets under uncertainty. Given these results, a measure of portfolio "per­formance" (which measures only a man­ager's ability to forecast security prices) is denned as the difference between the actual returns on a portfolio in any par­ticular holding period and the expected returns on that portfolio conditional on the riskless rate, its level of "systematic risk," and the actual returns on the mar­ket portfolio. Criteria for judging a port­folio's performance to be neutral, superior, or inferior are established. Read Full Text at http://us.share.geocities.com/iklan_aja/Michael.C.pdf

Risk, the Pricing of Capital Assets, and the Evaluation of Investment Portfolios: Comment

In a classic article appearing in this Journal, Jensen presented empirical re­sults from which he concluded that mutual fund portfolios showed "inferior" performance over the 10-year period 1955-64 after the deduction of all oper­ating expenses, management fees, and brokerage commissions generated in trading activity.1 Jensen argued further that, as a group, the mutual funds performance was neutral when all operating expenses and brokerage commissions were added back to the fund returns; therefore, the resources spent by the funds in attempting to forecast security prices did not yield higher portfolio returns than those which could have been earned by randomly gen­erated portfolios. Finally, Jensen suggested that his evidence supported the "strong" form of the efficient market hypothesis—that is, the current prices of securities completely reflect the effects of all information concerning the securities, and efforts to acquire and analyze this information cannot pro­duce consistently superior results. This comment will demonstrate that Jensen's empirical analysis and conclusions were based on questionable methods of estimating the mutual fund rates of return and levels of systematic risk. More specifically, it will be shown that Jensen's methodology (1) understated the mutual fund rates of return (and therefore understated the measures of excess return), and (2) introduced unnecessary measurement error into the analysis by assum­ing that the measures of systematic risk for the mutual funds were station­ary over time. Read Full Text at http://www.geocities.com/castro_che2000/Norman.E.pdf

MUTUAL FUND PERFORMANCE

Within the last few years consider­able progress has been made in three closely related areas—the theory of portfolio selection,1 the theory of the pricing of capital assets under con­ditions of risk,2 and the general behavior of stock-market prices.3 Results obtained in all three areas are relevant for evalu­ating mutual fund performance. Unfor­tunately, few of the studies of mutual funds have taken advantage of the sub­stantial backlog of theoretical and em­pirical material made available by recent studies in these related areas. However, one paper pointing the direction for future studies of mutual fund performance has appeared. Drawing on results ob­tained in the field of portfolio analysis, Jack L. Treynor has suggested a new predictor of mutual fund performance4— one that differs from virtually all those used previously by incorporating the vol­atility of a fund's return in a simple yet meaningful manner. This paper attempts to extend Trey-nor's work by subjecting his proposed measure to empirical test in order to evaluate its predictive ability. But we will also attempt to do something more —to make explicit the relationships be­tween recent developments in capital theory and alternative models of mutual fund performance and to subject these alternative models to empirical test... Read full text at http://www.420megs.com/users/iklan/Mutual-Fund-Performance.pdf