Before making an investment decision, every investor should examine the fund’s goals and objectives and the ability of its management to achieve them.
One must also evaluate the services provided by the fund and the costs of such services.
Much information is contained in the fund’s prospectus that, by law, must be furnished to all potential investors before a purchase application can be accepted by the fund. Now we discuss statements of investment objectives and policies, risk factors, investment restrictions, costs and fees, and other miscellaneous information contained in a mutual fund prospectus.
Investment Objectives and Policies
Mutual funds can be classified into various categories according to their objectives.
Capital gains or growth funds cater to the needs of those investors who prefer future long-term capital gains over immediate dividend income. Their invest- ments are largely made in established companies that have demonstrated the ability to expand faster than the nation’s economy.
Income funds basically favor securities with above-average, current income potential, although growth possibilities are not ruled out. Since their objective is to select stocks with high and stable dividend payments, income funds offer greater price stability than capital gains and growth funds.
Growth and income funds invest to realize a combination of capital gains and current income. However, some funds seek income as the primary objective and growth as a secondary aim, while others seek to maintain a balance between the two. Funds seeking both growth and income generally invest in a more broadly diversified group of securities than those who concentrate on generat- ing current income.
Index funds are designed to match the performance of a key stock market index.
These funds operate with the idea that matching the selected market average will produce better long-term results than the efforts of money managers who try to beat the market. An example of an index fund relates to the situation where the portfolio manager attempts to match the S&P 500 Index. The rationale of the indexer—exemplified by Vanguard Funds founder John Bogle—is that most active fund managers fail to beat market averages over the long term. Active managers reply that indexers are not very demanding and that they settle for mediocre returns.
Balanced funds hold bonds and preferred stocks in addition to common stocks in order to minimize market risk.
The important characteristics of objectives for various types of mutual funds are presented in the accompanying boxed insert.
Risk Factors
An important section contained in every prospectus deals with the risks that fund managers’ plan to assume. For instance, one prospectus may specify that, in markets seeking capital appreciation, it will purchase stocks of small companies trading on OTC market that have a history of greater price vola- tility than the stocks of more mature companies. Another prospectus may declare: “We expect to be fully invested in stocks under most market
conditions.” A third prospectus may caution that the fund deals in call and put options. These statements should be taken into account in determining the riskiness of the fund.
Investment Restrictions
Besides determining the riskiness of a fund, it is also important to note the investment restrictions imposed on the fund as well. Of course, every prospec- tus contains the usual investment restrictions imposed by the Investment Company Act of 1940. But in addition, it may also impose other restrictions on the portfolio managers. A list of typical restrictions includes the following:
• The fund will not indulge in short selling
• The fund will not purchase securities on margin
• The fund’s assets will be diversified so no more than 7.5 percent of the total is invested in a single industry group
• The fund will not borrow more than 3 percent of the total assets for meet- ing emergencies.
Many funds have left these restrictions wide open.
Past Performance
Mutual funds generally compare their five-year track record with S&P’s 500 Index or the Dow Jones Industrial Average. The prospectus also reveals such important data as the ratio of expenses to average net assets and the portfolio turnover rate. While past performance does not guarantee future performance, a good track record is certainly an attractive feature of any fund. Also, a low ratio of expenses to average net assets of up to 1 percent and a moderate portfolio turnover rate (say, 30 to 40 percent) might demonstrate that the fund is efficiently run.
CHARACTERISTICS OF SELECTED MUTUAL FUNDS
Type Characteristics
Aggressive Growth Key Strength: Growth potential in rising markets Main Weakness: High vulnerability to slumps
Investor Profile: Risk takers who will not need cash for at least three years Growth Key Strength: Long-term growth
Main Weakness: Scant protection from market drops
Investor Profile: Long-term investors who want capital growth with roughly market level risk
Type Characteristics
Value Key Strength: Buy out-of-favor stocks not widely followed or recommended by analysts
Main Weakness: Upturns in performance may not occur and may take considerable time for the market to recognize value, because they may be temporarily out-of-favor with investors
Investor Profile: Contrarians, investors who desire low P/E ratios, low price-to-book value
Total Return Key Strength: Comparatively steady gains in variety of market conditions Main Weakness: Tepid results in high times
Investor Profile: Risk-averse investors looking for capital growth and moderate income
International Key Strength: Can outpace US stocks
Main Weakness: Vulnerable to currency fluctuations Investor Profile: Growth investors who want diversity Gold Key Strength: Gains not dependent on US stock market
Main Weakness: More ups and downs
Investor Profile: Investors who want to hedge against inflation Bond Fixed Income Key Strength: Dependable monthly income
Main Weakness: Rising interest rates can zap principal
Investor Profile: Income seekers and equity investors looking to diversify
Fund Information
Several financial information services help investors track fund information concerning fund performance characteristics and portfolio investment. These include Lipper Analytical Services, Morningstar Mutual Funds, and Value Line Mutual Fund Survey. Information con- tained in these publications allows investors to identify particular funds that meet their own objectives and helps them make better informed decisions. However, since past perfor- mance is an unreliable predictor of future performance, an overuse of rankings and ratings generated by these fund information services can lead to poor decisions. During short reporting periods, usually the winners are the most volatile funds that often do not repeat their short-term successes. A fund industry observer once famously said of this riches to rags trend: “And the first shall be last.” Finally, over the long run, different fund types tend to enter into the winner’s circle. So, in making fund selection, take both a short-term and a long-term view of fund performance.
Costs and Fees
The SEC requires every fund to include a table of all fees toward the front of the prospec- tus, followed by a hypothetical total of all fees for several years. A pure no-load fund usu- ally indicates this fact on the cover, while front-load, low-load, and back-load funds
disclose costs inside the prospectus. Notwithstanding these mandated dis- closures, every investor should be creative in identifying additional costs that are not self-evident. For instance, instead of stating that all dividends are sub- ject to the usual full front-end load, one prospectus puts it this in a round- about way: “Dividends will be reinvested in additional full and fractional shares at the public offering price (net asset value plus a sales charge).”
Miscellaneous Information
The back pages of the prospectus contain valuable information on additional services available through the fund. These include, among other items, share purchases, sales and exchange privileges, transfers between funds within the family, participation in systematic withdrawal plan, dividend distribution, rein- vestment, and automatic deposit and withdrawal plans. Information is also pro- vided on telephone switches, check writing privileges, and other related services provided by the fund.