How to Navigate Your Mutual Fund Prospectus

Knowing what’s really going on in your fund is key.

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Even if you're a long-time investor, chances are you haven't read many mutual fund prospectuses. Indeed, for many investors, the main function of a prospectus is to serve as lining for the nearest garbage can.

To a certain extent, that's understandable. Fund prospectuses aren't exactly thrilling reads, and in many cases they can seem nearly impossible to get through.

But reading a prospectus doesn't need to be a complicated—or even time-consuming—process. Each prospectus will be different, but here are some things to look for when reading one:

Fees. This is an easy one. A prospectus will tell you how much your fund charges you and will give you a breakdown of how those fees are split. This breakdown will include management fees and, if the fund charges them, 12b-1 fees. You'll also probably see a category for "other expenses," which include transfer agent costs and administrative costs.

[See Understand Your 401(k) Fees.]

There's a heated debate among fund experts about how much investors should concern themselves with fees, and the merits of each side are beyond the scope of this article. Suffice it to say, though, that if you're dealing with two comparable funds, fees (the lower the better) could play a large part in your decision.

Strategies and risks. Fund prospectuses have at least one section (sometimes two) about each of these topics. If you're already invested in the fund whose prospectus you're reading, much of what you'll find here won't come as a surprise. For instance, if your fund has a growth or value bias, or if management prefers large-cap stocks or small-cap stocks, chances are that's something you knew about going in.

Nevertheless, there are things worth watching for. For instance, can your fund invest in derivatives? Can management engage in short sales? If the answer to either of these questions is "yes," there's a good chance you'll find that out by looking at these sections. It's important to note, however, that just because a fund says it might follow one of these strategies, that doesn't mean management is actively employing any at the moment.

[See Get to Know Your Asset Classes.]

Turnover. A fund's turnover ratio measures the percentage of its portfolio that has been replaced in the period in question. If the turnover ratio is high, that means that management is actively trading. If you're looking for a fund that buys and holds, a high turnover ratio could be a turnoff.

Moreover, trading can be expensive, and high turnover ratios can translate into high trading costs. Except in unusual cases, though, this will often be a peripheral concern at best.

Performance. A prospectus will provide you with performance graphs that will give you a sense of how the fund is doing. Remember, of course, that it's hard to look at performance numbers in isolation. The best way to grade your fund's performance is to compare its after-expense returns against the returns of a benchmark that accurately reflects the fund's strategy and holdings.

[See Why You Should Fire Your Broker.]

Management. There are two things to keep an eye out for here. First, has the fund added any managers recently? Second, have any managers left? The latter is generally more consequential than the former. If the old manager has been replaced by a new one, it's looking into what, if any, changes the new one has planned for the fund's strategy.

Ultimately, reading a prospectus won't provide you with very much entertainment. But it will help you get a better grasp of the investment that you own. There's a reason why funds are required to provide investors with prospectuses. It's because transparency empowers investors to make smart decisions. But at the end of the day, it's what you do with the information that counts.