Know Your Fund

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. You get all these documents and other relevant information on fund companies Web sites.

Lets try to extract the pertinent information from the documents –

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? ou should check to see whether or not the fund's objectives match your own personal investment objectives, since you probably only want to invest in funds that have similar goals to your own. 

2. Strategy.

The prospectus also describes the types of stocks, bonds, or other securities in which the fund plans to invest. 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.

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 example risks associated with small cap companies, foreign companies, and lower quality bonds.

4. Expenses.

It costs money to invest in a mutual fund, and different funds have different fees. This will help you check out various kind of fees the fund charges such as management fees, redemption fees, various kinds of sales commission the company charges (loads), etc.

5. Past Performance.

The prospectus has chart known as the "Financial Highlights" or "Per-Share Data Table" that 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. The prospectus may also use a growth of $10,000 graph 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. At this point, many funds identify the name and experience of the fund manager or managers.

Annual Shareholder Report

You should use these annual reports to check whether or not your fund is performing according to your expectations. The reports include a list of the fund's financial statements, a list of the fund's securities, letters from president and fund mananger. A good shareholder report is like a biography in that it sets out what happened to the fund over the past quarter, six months, or year, and why. It's like a blueprint because it sets before you all the investments—stocks, bonds, and other securities—that the fund has made.

Fund Performance

The report should compare your fund's performance to both a benchmark, such as the S&P 500 Index (the standard benchmark for large-company stock funds) or the Russell 2000 Index (for small-company funds), as well as to the average performance of funds with similar investment strategies. You should check to see whether or not your fund managed to beat its peers

When evaluating your fund's performance, be sure that the benchmark the fund chooses is appropriate for its style. For example, a technology fund shouldn't compare itself to the Dow; it should measure its performance against a technology benchmark.

In addition to benchmark comparison, the report should give you an idea of how the fund has performed over various time frames, both short and long term.

Letter from the Portfolio Manager

This is a fund-specific examination of the recent performance—and therefore much more important to you as a fund shareholder. Well-written shareholder letters discuss individual stocks that the fund owns and the industries in which the fund invested. A good manager letter will also explain what broad market trends might have fueled or hindered your fund's performance.

Portfolio Holdings

Funds often list the portfolio's largest holdings and provide some information about what these companies do or why the manager owns them. Some reports will also indicate, via a pie chart or table, the sectors in which the fund is heavily invested.

Financial Statements

A fund's annual report concludes with its financial statements. Brace yourself: There's a lot of data here. In fact, this is where Cost-conscious investors get a lot of the data before calling shots.

You should take a look at the following: First, examine what's known as the fund's Selected Per-Share Data. This is usually the last page of actual information, located just before the legal discussion of accounting practices. Here you'll find the fund's NAVs, expense ratios, and portfolio turnover ratios for each of the past five years (or more). Check to see if the fund's expense ratio has gone down over time and whether its turnover rate has changed much.

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