I Ran A Marathon! Also, Here’s How to Read a Prospectus

I ran the Philly Marathon this past Sunday! It was my first, and I definitely didn’t run it fast, but I finished. I wasn’t a fan of the rain and snow at the end though. Anyway, back to business…

Many investors that I speak with have their savings invested in a combination of mutual funds. Usually, owned through tax-advantaged accounts like 401k’s and IRAs. This is a good way to invest, although I often notice investors don’t know what fees they are paying. This is an intentional feature of the mutual fund market, unfortunately. Mutual fund providers must provide certain cost information in a prospectus, but many providers intentionally make this information inaccessible.

Three things to check in any mutual fund prospectus

Fortunately, there are only a few things you need to check in a prospectus. Even though each prospectus might be long and complicated, you can focus on these three things.

1. Is the fund managed actively or passively?

The fund manager is required to provide a discussion of the fund’s investment objectives and goals, as well as investment risks and performance. This is usually where you can tell if a fund is actively managed or not.

Active funds typically say things like “seeks to outperform the ___ index” or “maximize total returns”. Active funds might also mention specific strategies like “market timing”, “fundamental analysis”, “technical analysis”, or “sector allocation”.

The key phrases to look for to identify passive funds are “seeks to track the ___ index”, or “seeks to replicate the performance of the ___ index.” Passive funds will often directly state that they employ a passive fund management policy.

The management style of the fund is the largest factor affecting fees you will pay. Active management takes time and skill, and investors in those funds have to pay for the management teams to spend time selecting securities, developing strategies, and trading positions effectively. On the other hand, passive managers are generally focused on automating these tasks using algorithms. So, fees for passive funds are generally lower.

2. What is the expense ratio of the fund?

Although passive funds generally have lower fees than active funds, there is no guarantee. So, you have to do a little digging to find out the exact fee structure. The first, and most common, part of the fee structure is the expense ratio of the fund.

The expense ratio is a combination of:

1. the fund’s annual internal operating expenses that fund investors indirectly pay
2. certain other marketing and sales costs, called Rule 12b-1 fees

It is calculated as a percentage of your total investment in the fund. For example, if you invest $100,000 in a fund, and the fund manager sells $100 worth of your securities every year to pay their own expenses, the expense ratio would be:

$100 / $100,000 = 0.1%

These are costs that you will pay to the fund managers for as long as you own the fund. You won’t pay any additional money to the manager for these fees. The fund manager will just liquidate a small portion of the securities that you own indirectly through the fund to pay these internal costs.

It’s important to select a fund with a low expense ratio so that you are benefiting from your fund’s growth, and not your fund manager. As a point of reference, I would avoid entirely any fund with an expense ratio above 1%. Many good index funds can be found for an expense ratio of less than 0.3%, and the most efficient funds have expense ratios below 0.1%. There are even a few that have no fees at all.

It may seem silly to quibble over a few tenths of a percent, but that’s just because of a mathematical quirk that pops up when dealing with investment returns. A fee of 1% may sound low, but consider the fact that an equity fund might expect to achieve an 8% return in a year. With a 1% fee structure, for every eight dollars you earn in the market, you are paying one back to your fund manager. That’s a lot!

3. Are there load fees?

Load fees are less common than annual operating expenses, but you still have to check just in case. These are one-time fees that the fund investor pays upon buying (front-end load fees) or selling (back-end load fees) fund shares. Often, back-end fees are waived if the investor holds the fund shares for a certain period of time.

Competition amongst fund managers has helped get rid of a lot of these fees for most funds. They are legal though, so you have to double check. In most cases, I would not recommend buying a fund with any type of load fee.

Fund performance: Not very important

You’ll notice I didn’t include historical performance in my list. That’s because there are many problems using past performance data as a guide for investment:

• Investing returns are pretty volatile. This makes it hard to tell if good performance in the past is due to superior skill or just luck. There are lots of people in the casino that have been doing great today. That doesn’t mean that they are smart, or good at slots.
• Fund management companies have many ways to overstate past performance. In particular, many fund managers close down underperforming funds and merge their assets back into better performing funds. Depending on how they account for this process, this can mask periods of bad performance from their reported data.
• High-performing funds attract new investor money. As a fund grows in size and scale, the fund managers may become less able to exploit the market imperfections that allowed them to achieve good results in the past.

Another resource: The FINRA Fund Analyzer

The Financial Industry Regulatory Authority (FINRA) offers a service to fund investors to help compare different mutual funds and their fee structures. The FINRA fund analyzer is a great tool to help cut through all the extra information in a prospectus and get to what matters: strategy and fee structure. I’m a big fan. It’s probably a good idea to skim the actual prospectus to verify FINRA’s data though.