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Course 108
Important Fund Documents, Part 1

Introduction

You've seen the advertisements in the papers ("Five Stars!") and the pundits on TV, identifying their hot new pick of the month. And you probably know one or two lucky coworkers who made a mint at some point after taking a chance on some fund or another. But you can't have missed the recent tales about the downfalls of yesterday's favorite fund shops, the management scandals, and the huge, risky bets that cost many investors their retirement dreams.

Clearly, the experience of the last five years suggests that investors need more than performance numbers and hot tips to judge a fund. Before parting with your money, you need to be able to answer questions such as: What is the fund's investment strategy? What are that strategy's risks? How much does the fund cost? How does this fit in with my goals? And who runs the thing, anyway?

In order to answer these questions you need three valuable fund documents, produced by the company running your mutual fund: the prospectus, the Statement of Additional Information, and the annual report. When you request an information kit from a fund family, you'll usually receive the prospectus and the most recent shareholder report. (Many fund companies also make these documents available on their Web sites.) These documents are packed with legal jargon, convoluted sentences, and boilerplate information in order to fulfill the Securities and Exchange Commission's disclosure requirements and to protect the funds from legal liability. The language can be tremendously intimidating and reading it is dull work. But these documents are vital for mutual fund investors.

Here's how to get what you need from the prospectus and the Statement of Additional Information. (We'll cover the annual shareholder report in our next lesson.)

The Prospectus

The prospectus tells you how to open an account (including minimum-investment requirements), how to purchase or redeem shares, and how to contact shareholder services.

It also details six aspects of the fund that you need to know about before you decide to buy shares.

1. Investment Objective.The investment objective is the mutual fund's purpose. Is the fund seeking to make money over a long-term period? Or is it trying to provide its shareholders regular income each month? If you're investing for your young child's education, you'll want the former. If you're looking for a monthly dividend check, you'll want the latter. But investment objectives are often vague. That's why you'll want to check out the next section.

2. Strategy.The prospectus also describes the types of stocks, bonds, or other securities in which the fund plans to invest. (It does not list the exact stocks that the fund owns, though.) Stock funds spell out what kinds of companies they look for, such as small, fast-growing firms or big, well-established corporations. Bond funds specify what sorts of bonds they generally hold, such as Treasury or corporate bonds. If the fund can invest in foreign securities, the prospectus says so. Most (but not all) restrictions placed on the fund are also mentioned here, including references to short selling, leveraged purchases, and so on.

3. Risks.This section may be the most important part of the prospectus, but it's generally written in very broad language. Every investment has risks associated with it, and a prospectus must explain these risks. For instance, a prospectus for a fund that invests in emerging markets will reveal that the fund is likely to be riskier than a fund that invests in developed countries. Bond-fund prospectuses typically discuss the credit quality of the bonds in the fund's portfolio, as well as how a change in interest rates might affect the value of its holdings.

4. Expenses.It costs money to invest in a mutual fund, and different funds have different fees. A table at the front of every prospectus makes it easy to compare the cost of one fund with another. Here, you'll find the sales commission the fund charges, if any, for buying or selling shares. The prospectus also tells you, in percentage terms, the amount deducted from the fund's return each year to pay for things such as management fees and operational costs.

5. Past Performance.We all know the fund world's catch-all phrase: "Past performance is no guarantee of future results." But a fund's record can give you an idea of how consistent its performance has been. A chart known as the "Financial Highlights" or "Per-Share Data Table" provides the fund's total return for each of the past 10 years, along with some other useful information. It also breaks out the fund's income distributions and provides the year-end NAV.

Some prospectuses include additional return information in the form of a bar chart, which illustrates the fund's calendar-year returns for the past 10 years. This chart is a good way to get a handle on the magnitude of a fund's ups and downs over time. The prospectus may also use a growth of $10,000 graph (also known as a mountain graph, because the peaks and valleys resemble the cross section of a mountain) or a table comparing the fund's performance to indexes or other benchmarks to present return information. (Unless otherwise stated, total return numbers do not take sales charges into account, but they do take into account a fund's annual expense ratio.)

6. Management. The Management section profiles the folks who will be putting your money to work. As of March 2005 funds are required to list all of their team members in their prospectuses. Considerthe fund manager's tenure if it's relatively short, the fund's past record may have been achieved under someone else. Find out whether the manager has run other funds in the past. A peek at those funds could give you some clues about the manager's investment style and past success.

Statement of Additional Information

While the prospectus is packed with great information, it shouldn't be your sole source of data on a fund. A fund's Statement of Additional Information (SAI) contains more great tidbits about the fund's inner workings. You'll generally have to request this document by calling the fund company: Funds send out prospectuses and annual reports as a matter of routine, but SAIs are often considered second-tier documents

Fund families may consider SAIs secondary, but these statements usually provide far more detail than the prospectus about what the fund can and cannot invest in. Further, this document usually identifies just who represents your interests on the fund's board of directors and just how much you pay them for their efforts and how much these directors own of the fund.

Finally, you can find more details about your fund's expenses here. Shareholders in CGM Focus CGMFXwouldn't know they shelled out $24.2 million in brokerage fees in 2010 unless they had read the fund's SAI. SAIs also break down where 12b-1 fees go, if the fund charges them. (These are fees that the fund can use for marketing, rewarding brokers, and attracting more investors.) For example, Legg Mason Value Trust C(LMVTX) spent $25.3 million in connection with "share distribution and shareholder services," including broker compensation. It's your money; you should know where it's going.

Quiz 108
There is only one correct answer to each question.

1 Which of the following appears in all prospectuses?
a. All of the fund's holdings by name
b. The names of the board of directors.
c. Management fees.
2 The Investment Objective portion of the prospectus is most helpful in determining:
a. What the fund's general purpose is.
b. What types of securities the fund owns.
c. What sort of risks are associated with the fund.
3 What won't the Management section of a prospectus tell you?
a. Who the manager is.
b. What the manager's annual salary is.
c. What other fund experience the manager has.
4 For details about how your fund fees are spent, consult the:
a. Prospectus.
b. Statement of Additional Information.
c. Neither.
5 Which document usually is not included in the information kit that fund families send out?
a. Prospectus.
b. Statement of Additional Information.
c. Shareholder report.
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