Funds 108: Important fund documents, Part 1

By Morningstar.com

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 co-workers 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.

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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 businesses 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.

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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.

Continued: Expenses

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