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Prospectus Hunting

11/22/00 03:09:36 PM PST
by Han Kim

Here's how to read a prospectus and get the essentials from it.

Before putting any money into a mutual fund, read the prospectus. A prospectus is a document prepared by the mutual fund company that provides general information on a specific fund or group of funds, including the fund's objectives; the fund's managers and their experience; the fees and charges associated with the fund; and policies and restrictions. You can call a mutual fund company or your brokerage firm and have a prospectus mailed to you, or nowadays, you can often view them online at the mutual fund company's Website. Although the prospectus doesn't provide all the information you may be looking for, it is still a starting point and your main source of information.

Of course, not all fund prospectuses are the same, but generally they will contain the points shown in Figure 1. It is to your advantage to go through the prospectus of any fund you may be considering adding to your portfolio.

FIGURE 1: PROSPECTUS ESSENTIALS. When you're looking over a mutual fund's prospectus, make sure that you find out these essentials about the mutual fund.


The importance of paying attention to the fund's investment objectives or goals is to determine whether they are in stride with your personal investment goals. There's no point in investing in a fund that provides current income when your investment objective is to achieve capital growth. The objectives or goals of the fund are usually explained briefly; T. Rowe Price's objective of their Prime Reserve Fund is, for example, "preservation of capital, liquidity, and, consistent with these, the highest possible current income." And that's it. This investment objective does not delve into details, but it gives you enough information to determine whether the fund is right for you.


The fund strategy briefly explains how the fund plans to reach its goals. As mentioned earlier, the strategies will vary from fund to fund. An example can be seen in Figure 2. In strategy statements, you should take note of words like "generally" and "primarily." These words are there to give you a sense of what the strategy is but also serves to give the manager(s) the flexibility to make changes depending on circumstances.

Berger Small Company Growth Fund -- Investor Shares Ticker Symbol BESCX

The fund's goal and principal investment strategies

The fund aims for capital appreciation. In pursuing that goal, the fund primarily invests in the common stocks of small companies with the potential for rapid earnings growth.

The fund's stock selection focuses on companies that either occupy a dominant position in an emerging industry or have a growing market share in a larger, fragmented industry.

The fund's investment manager generally looks for companies with:

  • A proprietary technology, product, or service that may enable the company to be a market share leader
  • Strong entrepreneurial management with clearly defined strategies for growth
  • Relatively strong balance sheets.

  • Under normal circumstances, the fund invests at least 65% of its assets in equity securities of companies whose market capitalization, at the time of initial purchase, is less than the 12-month average of the maximum market capitalization for companies included in the Russell 2000 Index (Russell 2000). This average is updated monthly. The fund's investment manager will generally sell a security when it no longer meets the manager's investment criteria or when it has met the manager's expectations for appreciation. The fund's investment manager may actively trade the portfolio in pursuit of the fund's goal.

    FIGURE 2: FUND STRATEGIES, BERGER SMALL COMPANY GROWTH. Fund strategies will vary from fund to fund. Take note of words like "generally" and "primarily," among others; these are there to give you a sense of what the strategy is but also serves to give the manager some flexibility.


    Every investment carries risk, and some will be riskier than others. This section of the prospectus contains information on the main risks that could affect the net worth of your portfolio if you were to invest in the fund. For example, global funds carry other risks, such as political instability, exchange rates, government regulations, and diplomatic tensions. In one of its prospectuses, Invesco International Funds, Inc., discusses the risks involved with investing in its international funds (Figure 3). Here, you can see some of the risks involved in investing in foreign securities.


    Investments in foreign and emerging markets carry special risks, including currency, political, regulatory, and diplomatic risks.

    Currency risk. A change in the exchange rate between US dollars and a foreign currency may reduce the value of a fund's investment in a security valued in the foreign currency, or based on that currency value.

    Political risk. Political actions, events, or instability may result in unfavorable changes in the value of a security.

    Regulatory risk. Government regulations may affect the value of a security. In foreign countries, securities markets that are less regulated than those in the US may permit trading practices that are not allowed in the US.

    Diplomatic risk. A change in diplomatic relations between the US and a foreign country could affect the value or liquidity of investments.

    FIGURE 3: FOREIGN SECURITES FUNDS. Here is an example of some of the risks involved in investing in foreign securities.


    There are different types of fees and expenses involved in a mutual fund. Mutual funds are generally divided into two types, load and no-load. The load is a sales commission that can be charged upfront when purchasing the fund (front-end load) or at the end when selling the fund (back-end load). While load funds charge load fees, both load and no-load funds funds charge other fees as well; with no-load funds, these are what you should look for. Such fees include management fees, distribution or 12b-1 fees, and other expenses.

    The management fee is the percentage taken out annually to pay for incurred expenses necessary to manage the fund. The 12b-1 fees cover the marketing and distribution costs, which are separate from other management expenses. The "other" expenses include any additional fees or expenses the fund incurs. There is even a fee for account balances below a certain level. All these expenses -- the management fee, 12b-1 fee, and other miscellaneous fees -- add up to give you the expense ratio or total annual fund operating expenses. This is the percentage you pay every year you hold the fund, in addition to the load if the fund is a load fund.

    In a mutual fund's prospectus, expect to see in the fees and expenses section a hypothetical example of how much you would end up paying over time. Examples are typically given for a $10,000 investment and assuming a 5% annual return, so you can compare the fees with those of other funds. Figure 4 shows the fees and expenses section from an American Century prospectus for five of its growth funds.


    There are no sales loads, fees, or other charges:

  • To buy fund shares directly from American Century
  • To reinvest dividends in additional shares
  • To exchange into the investor class shares of other American Century funds
  • To redeem your shares.

  • The table below describes the fees and expenses you will pay if you buy and hold shares of the funds.


    The examples in the table below are intended to help you compare the costs of investing in a fund with the costs of investing in other mutual funds. Assuming you:

  • Invest $10,000 in the fund
  • Redeem all of your shares at the end of the periods shown below
  • Earn a 5% return each year
  • Incur the same operating expenses as shown above
    . . . your cost of investing in the fund would be:

  • FIGURE 4: FEES AND EXPENSES. This section of the American Century Growth Funds prospectus deals with how much you would end up paying in fees and fund expenses over a period of time. All examples assume a 5% annual return on a $10,000 investment, so you can compare the fees with other funds.


    By now you've seen, time and again, the disclaimer that "past performance does not guarantee future results." Still, it's a good idea to get insight into how the fund has performed over the years. There is no way to know how a fund will perform in the future, but you should go with one that has consistently done well. The difficulty comes in when you are evaluating a fund that has recently entered the market. With a relatively new fund, there is always a high risk.

    The performance of a fund will often be given as an average return for the past three months, six months, one year, three years, five years, and 10 years. Long-term average returns are more significant. These figures should be compared to similar funds and a relevant benchmark. For example, T. Rowe Price's Equity Index 500 is compared with the Standard & Poor's 500 index in Figure 5.

    FIGURE 5: PERFORMANCE COMPARISON. Here, the T. Rowe Price Equity Index 500 is compared with the S&P 500.


    The management team behind a fund should not be overlooked. Look at how many years the manager(s) have been with the fund and how well the fund has performed during those years. In addition, look at the board of directors of the company and see how many of them are from outside the company.


    There are certain criteria that you should look for in a prospectus. What are the objectives of the fund? (Is this fund trying to do what I want?) What are the strategies of the fund? (How is it going to do it?) What kind of risk is involved? (How vulnerable will I be?) What kind of fees and expenses are involved? (What will it cost me?) What kind of performance has the fund had in the past? And finally, who's in charge of the fund? Use the checklist in the sidebar above to help you determine whether the fund is right for you.

    With the right knowledge under your belt, you should be able to select funds that are right for you. Select those that are in line with your investment objectives. Select those with a strategy you agree with. You also want your funds to have a risk level you can tolerate. And if the fund has a good track record and management team, then all the better. Last, but not least, don't overlook your annual expenses, since they can eat into your overall returns.

    Han Kim

    Staff Writer

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