Information describing the mutual fund is disclosed to investors in a legal document known as a prospectus. The most important information will appear in the first five pages of the mutual fund’s description and include:
- the mutual fund’s investment objective
- the mutual fund’s principal investment strategies and risks
- the fees and expenses a shareholder in the mutual fund will pay
- the mutual fund’s investment performance over time, both absolute and relative to a broad-based market benchmark
Under the law, this information must be complete and truthful. The people who prepare and sign the prospectus are liable to shareholders for omissions and misstatements of material fact.
More often than not, the representations made in a prospectus will prevail over whatever verbal representation the salesperson may have made in their pitch. Therefore, it is very important to read the prospectus and have a basic understanding of the mutual fund’s investment strategy and risks, its fees and expenses, and historical investment performance.
Experience has shown that one of the common investor pitfalls is relying too much on a salesperson’s pitch and not realizing fully what they have bought until it’s too late.
The Investment Objective and Principal Investment Strategies
The mutual fund’s investment objective will be disclosed toward the front of the prospectus. Mutual funds that invest primarily in equities seek capital appreciation over time. Mutual funds that invest primarily in bonds focus on generating income combined with preserving capital. Balanced funds invest in both equities and bonds and pursue a combination of both objectives.
The prospectus will also identify the mutual fund’s principal investment strategies. If the mutual fund is a stock fund, the prospectus will identify the type of companies it primarily invests in; for example, large companies, small companies, US-based companies, global companies, or industry-specific companies. The prospectus will also identify what percentage of the mutual fund’s assets will be invested in these companies. Finally, the prospectus may specify a range of how many different companies the mutual fund will own.
Some mutual funds will focus on a small number of companies in the hopes that their portfolio managers guessed correctly to maximize gains. Others will diversify across a broad spectrum of companies in the hopes of mitigating potential losses.
How Index Funds and Actively Managed Funds Differ
Another very important feature is whether the mutual fund is an index fund or an actively managed fund.
An index fund – also known as a passively managed fund – invests in only the stocks or bonds listed in a specific index. For example, an S&P 500 Index fund owns only the 500 stocks listed in the Standard & Poor’s 500 index and nothing more. The only investment decision a portfolio manager makes is to re-balance the portfolio when the S&P 500 Index changes the composition of its listings—hence, the name passively managed. The investment performance of an index fund will match the investment performance of the index it tracks, less fees and expenses.
An actively managed fund, on the other hand, seeks to outperform the investment performance of the index it tracks. In an actively managed fund, a portfolio manager makes investment decisions on which individual stocks to buy, sell, or hold based on research and analysis—hence, the name actively managed. Because the fund must hire a portfolio manager to research and make decisions, the investment advisory fees for actively managed funds are significantly higher than passively managed funds.
It’s important to note that statistical data show that most actively managed funds do not consistently outperform their index or their passively managed counterpart. For the average investor, conventional wisdom would point to the passively managed funds as the best option.
What Are My Principal Investment Risks?
Mutual funds are not bank deposits, and therefore an investor’s principal is not guaranteed and is subject to risk of loss. /The prospectus will include a section that summarizes the principal investment risks of investing in the mutual fund. A mutual fund’s risk will depend on its investment strategies. For example, a mutual fund that invests in stocks will be at risk that the business of a major holding fails, or that the overall market turns bearish, or some unforeseen random event adversely affects an entire industry.
A mutual fund that concentrates in a single industry, such as transportation, runs the risk that a spike in oil and gas prices will adversely affect the entire industry. A mutual fund that invests globally runs the risk that a strong U.S. dollar will drive down the exchange value of stocks denominated in a foreign currency.
While many portfolio managers diversify their holdings to mitigate catastrophic risk, it is important to understand the risks and be willing and able to accept the risks before you invest. A well-written prospectus will identify these risks, some in such mind-numbing detail that many an investor simply ignores it, which is a common mistake that should be avoided.
Next: In part 4, we will cover important information on how the mutual fund’s investments have performed over time.
Charles Field is Managing Partner of the San Diego office of Sanford Heisler Sharp and Chair of the firm’s Financial Services Litigation Practice Group.