Investing in Mutual Funds: Part Three

Do not make assumptions about a fund based solely on its name, past performance, rankings, ratings and fund managers. Be sure to gather and review as much information about the fund in order to make a sound investment decision.

Sources of Information

Prospectus

If you purchase mutual fund shares, the fund is required to send you a prospectus. However, you should obtain and read a fund's prospectus in detail before investing. The prospectus contains valuable information, such the fund’s investment objectives, investment strategies, risks, fees and expenses, historic performance and managers and advisers. It also describes how to go about purchasing and redeeming shares.

Mutual fund prospectuses may seem overwhelming at first, buy they contain a world of valuable information. Pursuant to SEC requirements, funds must include specific information in their prospectuses and must present important data in a standard format, which aids investors when comparing different funds.

The following can be found in a mutual fund prospectus:

  • Date of Issue — The date of the prospectus is located on the front cover. Mutual funds are required to update their prospectuses at least once a year, so checking the date will ensure that you have the most recent version.
  • Risk/Return Bar Chart and Table — Bar charts can also be found near the front of the prospectus, usually after a description of the funds characteristics. The bar chart will display the fund's annual returns for each of the last 10 years. If a fund has had an annual return for at least one calendar year, it must include the bar chart.

Funds must also include a table outlining both before and after taxes for the past 1, 5 and 10-year periods, as well as broad-based index returns for purposes of comparison. Here's what the table will look like:


1-5-year(or10-year (or
yearlife of fund)life of fund)
Return before taxes____%____%____%
Return after taxes on distributions____%____%____%
Return after taxes on distributions
and sale of fund shares
____%____%____%
Index (reflects no deductions for
[fees, expenses, or taxes])
____%____%____%

Note: you should thoroughly review any footnotes or supplemental explanations to make sure that you fully understand the bar chart and table data. In addition, take into account that the bar chart and table for a multiple-class fund will usually display performance data and returns for only one particular class.

  • Fee Table — a table that breaks down a fund's fees and expenses typically follows the bar chart and returns table. The fees shown usually include the shareholder fees and annual operating expenses. The fee table will also include a $10,000 hypothetical investment over a 1-, 3-, 5-, and 10-year period that will allow you to compare costs among different funds.
  • Financial Highlights — This section contains audited information pertaining to the fund's performance for each of the past 5 years and is located towards the back of the prospectus. NAVs, total returns, and numerous ratios, including expenses to average net assets, net income to average net assets and the portfolio turnover rate, can also be found in this section.

Profile

A mutual fund "profile” summarizes key information in the fund's prospectus, such as the fund's investment objectives and strategies, risks, past performance, fees and expenses, after-tax returns, investment adviser, and other information.

Statement of Additional Information (“SAI”)

The SAI breaks down a fund's operations in greater detail than the prospectus. The SAI will contain information pertaining to the fund's financial statements; the history of the fund; fund borrowing and concentration parameters; the identity of officers, directors, and control persons; investment advisory and other services; commissions; tax issues; and performance. If requested, the fund must send you an SAI, also know as “Part B.” The back cover of the fund's prospectus usually contains information for obtaining an SAI.

Shareholder Reports

A mutual fund also must provide shareholders with annual and semi-annual reports within 60 days after the end of the fund's fiscal year and 60 days after the fund's fiscal mid-year. These reports contain a variety of updated financial information, a list of the fund's portfolio securities, and other information. The information in the shareholder reports will be current as of the date of the particular report (that is, the last day of the fund's fiscal year for the annual report, and the last day of the fund's fiscal mid-year for the semi-annual report).

Past Performance

Past performance should not be given as much importance as investors give it. Although rankings and ratings tout how well a fund has performed in the past, studies show that the future results are often different. This year's best fund can easily become next year's disappointment.

Investors should first look into how long a fund has been in existence. Smaller, newly created funds sometimes have stellar short-term performance records as they may invest in only a few successful stocks that can have a large impact on performance. As these funds increase in size and add more stocks to their portfolios, each stock will have less of an impact on the funds’ overall performance. This makes it more difficult to repeat past results.

Past performance does serve to indicate how volatile (or stable) a fund has been. Funds that have a history of volatility are generally riskier investments. If you are in need of liquidity to meet certain goals or obligations in the near-term, you should not risk investing in a historically volatile fund as you will most likely not have enough time to weather declines in the stock market.

Looking Beyond a Fund’s Name

A fund labeled “ABC Stock Fund” does not necessarily invest 100% of its cash in stocks. The SEC requires a mutual fund purporting to invest in a particular type of security to invest at least 80% of its assets in that specific security. Therefore, funds can still invest 20% of their holdings in other types of securities, including securities that may not be suitable for your investment objectives.

Bank Products versus Mutual Funds

Many commercial banks sell mutual funds, some of which are proprietary. These funds are not bank deposits, and, as a result, they are not insured by the Federal Deposit Insurance Corporation (FDIC).

Glossary of Key Mutual Fund Terms

12b-1 Fees — fees paid out by the fund to cover marketing, sales of fund shares and shareholder services.

Account Fee — a fee to cover the maintenance of an investor’s account. For example, if an account balance falls below a specified dollar amount, the account owner may have to pay an account fee.

Back-end Load — a sales charge investors pay when they redeem (sell) their mutual fund shares. The deferred sales charge is typically used to compensate brokers.

Share Classes — different classes of shares, such as A shares, B shares, etc…, issued by a mutual fund. Each class holds the same pool of securities and abides by the same investment objectives and policies. The difference lies in shareholder services, distribution arrangements, and fees and expenses. Therefore, each fund will perform differently.

Closed-End Fund — a fund offered by an investment company that sells a fixed number of shares in an initial public offering. The closed-end fund shares then trade on a secondary market, such as the NYSE or NASDAQ.

Contingent Deferred Sales Load — a back-end load that depends on the length of time the shares were held. For example, if an investor holds his or her shares for one year, the contingent deferred sales load might be 5%, after two years, 4%, until the load reaches zero.

Conversion — a feature that allows investors to automatically change from one share class to another after a certain period of time. One benefit is lower annual expenses. The fund's prospectus will state whether a share class will convert to another class.

Deferred Sales Charge — see “back-end load” (above).

Distribution Fees — "Distribution fees" include fees such as commissions to wholesalers and brokers who sell fund shares, as well as fees for the advertising and printing and mailing of prospectuses and sales materials. They are sometimes referred to as “12b-1 fees.” Exchange Fee — a fee assessed when mutual fund shareholders exchange or transfer to another fund within the same fund group.

Exchange-Traded Funds — a fund managed by an investment company whose objective is to mimic a particular market index’s return. ETF shares trade on a secondary market and can only be redeemed from the ETF fund itself. ETF share redemptions are executed in very large blocks.

Expense Ratio — annual operating expenses are comprised of management fees, distribution (12b-1) fees, and other expenses. They are expressed in terms of percentage of average net assets.

Front-end Load — a sales charge assessed when investors buy mutual fund shares. The front-end load is typically used to compensate brokers and reduces the amount of shares purchased.

Index Fund — a type of mutual fund or unit investment trust (UIT) whose investment objective is to mimic a particular market index’s returns. The most popular indexes include the S&P 500, the Russell 2000, and the Wilshire 5000.

Investment Adviser — a person or entity dedicated to giving advice related to stocks, bonds, or mutual funds to clients for compensation. Some investment advisers manage portfolios of securities, such as mutual funds.

Investment Company — a company or entity dedicated to the business of investing in securities. The most commonly know investment companies are mutual funds, closed-end funds, and UITs.

Load — a sales charge or fee

Management Fee — a fee paid to cover the fund's portfolio management, such as investment adviser fees and any administrative fees not included in "other expenses." A fund's management fee falls under operating expenses.

Market Index — a market index is comprised of a "basket" of stocks representing a particular sector of the stock market. For example, the Dow Jones Industrial Average (DJIA) is an index of 30 “industrial” company stocks also know as “blue chip” companies.

Mutual Fund — an open-end investment company that pools money from investors and invests in stocks, bonds, short-term money market instruments, or a combination of such securities. Mutual funds shares are not purchased on secondary market. Instead shares are purchased directly from the fund or through a broker for the fund.

NAV (Net Asset Value) — the mutual fund's assets minus its liabilities. Pursuant to SEC rules, NAVs must be calculated at least once daily. NAV per share is calculated as follows: (assets – liabilities) / total number of shares outstanding.

No-load Fund — a fund that does not assess a sales load. However, a no-load fund may charge fees and operating expenses.

Open-End Company — a mutual fund or type of investment company.

Operating Expenses — the costs of running the fund, such as management fees, distribution (12b-1) fees, and other expenses.

Portfolio — an individual or entity's holdings of stocks, bonds, and/or other securities.

Profile — a summary of a mutual fund's costs, investment objectives, risks, and past performance. Not all mutual funds have a profile.

Prospectus — a comprehensive description of the mutual fund prepared for investors. The prospectus contains information about the mutual fund's costs, investment objectives, risks, and performance. All mutual funds have a prospectus. A mutual fund’s prospectus can be obtained directly from the mutual fund company or from a broker.

Purchase Fee — a shareholder fee assessed when mutual fund shares are purchased. Purchase fees are not the same as a front-end load. Redemption Fee — a shareholder fee assessed when investors sell or “redeem” mutual fund shares. Redemption fees are not the same as a back-end load. The SEC caps redemption fees at 2%.

Sales Charge or “Load” — a commission type charge investors pay when they buy (front-end load) or sell or redeem (back-end load) shares in a mutual fund. The SEC does not limit the size of a sales load, but FINRA rules cap sales loads at 8.5%; the cap may be lower depending on other fees and charges assessed.

Shareholder Service Fees — fees paid to personnel to address investor inquiries and provide investors with information about their funds. They are also sometimes referred to as “12b-1 fees.”

Statement of Additional Information (SAI) — funds are not required to disclose certain information that is not necessarily needed to make an informed investment decision. Still, investors can request a SAI, which is also known as "Part B" of the fund's registration statement.

Total Annual Fund Operating Expense — a fund’s total operating expenses, expressed in terms of a percentage of the fund's average net assets. This information can be found in the prospectus.

Conclusion

Mutual fund investing can become quite complicated. At the same time, stock brokers are not as knowledgeable or trustworthy as one might be led to believe. As a result, mutual funds can be mismanaged, misrepresented and unsuitable investments offered and sold in violation of federal and state securities laws, as well as in breach of a broker’s fiduciary duty. Stock brokers can also be held responsible for their negligence and failure to abide by securities industry rules and regulations. At the Law Offices of Robert Wayne Pearce, P.A. we know the nature, mechanics and risks of investing in mutual funds, as well as the applicable laws, rules and regulations governing those investments. Please contact us for a free consultation if you believe you have been harmed by your broker’s misconduct in connection with your mutual fund investments.

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