Mutual funds can appear about as logical as jumbo shrimp to the millions of people who have 401(k)’s, IRAs, and other investments that include these funds.
If you’re like many investors, you only have a vague idea how these funds work. Although there is a lot to evaluate when you’re choosing the funds that will fill your retirement or other portfolio, let’s concentrate on the very first step – What is a Mutual Fund Prospectus?
When you first started the process of setting up your retirement fund, you may have received a series of brochures that had a whole lot of words but very few of them made any sense.
These brochures are called prospectuses and we’re going to learn the basics that you need to know to make informed choices.
Mutual Fund Basics – Prospectus
Any explanation of mutual fund basics should start at the beginning and the beginning is the prospectus.
If you met with somebody who was setting up your retirement account he or she may have told you that the funds that you choose are entirely your choice and they can’t give you advice. If you heard this, find a new adviser if you’re not picking funds in an employer sponsored program.
If you’re stuck with that person or your regular adviser is pushing these products, there are three basic actions you must take: Be skeptical, ask every question you can think of, and keep your portfolio diversified. Don’t put all of your investment dollars in to one type of fund.
Think of the prospectus as the owner’s manual of a single mutual fund. It tells you what it is, what its investment goals are, and how it’s going to reach those goals, and how much they will charge you to make you money. These are the three items that you should focus on and these three items are where you’re skeptical, ask a lot of questions, and keep a good balance.
There are two types of prospectus: A statutory prospectus and a summary prospectus.
The statutory prospectus is the thick brochure that you probably received. If you aren’t skilled at reading these documents, head to the internet and see if the fund has a summary prospectus.
What to look at
First, what kind of fund is it? If it is a fund that invests in stocks, are they large cap stocks (big companies), small cap (up and coming businesses), or something in between? If it’s an index fund, what is the index? An index fund based on the S&P 500 is a common fund and a good choice.
The key is not to fill your portfolio with mutual funds of the same type. You want a cross section of different funds.
Next, what are its goals? Some are aggressive growth while others take a more conservative approach. Once again, a mix of strategies is best.
Finally, what is the past performance and what are the fees? If the fund has lost money or only made a few percentage points every year of its existence, it’s not beating the yearly rate of inflation and probably not a good choice.
Next, look at the fees. You have to subtract the fees from the rate of return to know what you can expect in terms of performance of the fund. Lower fees are generally better but if you can pay a little more and still have a better projected return in the end, the low fee may not be worth the small gains.
There is a lot more information contained in the prospectus. Much of this information is legal and compliance information which, realistically, isn’t important or even useful to people without an investing background. Ask the adviser or call the funds customer service number if you have questions about the other information in the prospectus.
This should get you started but there are plenty of resources online that will provide you with an even more in depth look. Websites like Morningstar.com are an excellent place to continue your mutual fund basics education and learn more about a mutual fund prospectus.
Buck Inspire says
Great breakdown. I didn’t know there were two types (statutory and summary). I gloss over it because all the legalese makes me dizzy. Way to focus on what is important. Thanks for the refresher!
Glen Craig says
It’s easy to get these things in the mail and just toss them but it’s important to try and understand what is happening in them.
Jon -- Free Money Wisdom says
Great explanation–I had no idea about the different types of mutual funds. Thanks for the info. It is definitely important to understand them! Knowledge is power.
The Better Investor says
This is a great start in understanding how to choose the right mutual funds. Before choosing a fund, you’ll also want to set a goal. For example, when do you want to cash out of your investment and for what use? A common goal is retirement, but it could also be an investment for a large purchase. Your goal and investment timeline will help you determine how much risk you are willing to take on to achieve your goal. The shorter your time horizon, the less risk you should generally take. These type of questions will help you decide what asset allocation is most appropriate for you. A lot goes into choosing a fund that is right for you. Some research and due diligence up front can make a world of difference in your portfolio’s long term performance.