Investing Classroom: Important fund documents

You've seen the advertisements in the papers and the pundits on TV, identifying their hot new pick of the month. And you probably know one or two lucky co-workers who made a mint at some point after taking a chance on some fund or another. But you can't have missed the tales about the downfalls of yesterday's favourite fund shops, the management scandals, and the huge, risky bets that cost many investors their retirement dreams.

Clearly, 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 fund: the prospectus, the Statement of Additional Information, and the annual report. When you request an information kit from a fund family, you'll usually receive the prospectus and the most recent shareholder report. (Many fund companies also make these documents available on their websites.) These documents are packed with legal jargon, convoluted sentences, and boilerplate information in order to protect the funds from legal liability. The language can be tremendously intimidating—and reading it is dull work. But these documents are vital for fund investors.

Here's how to get what you need from the prospectus and the Statement of Additional Information. (We'll cover the annual shareholder report in our next lesson.)

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 a number of aspects of the fund that you need to know about before you decide to buy shares.

1. Investment objective

The investment objective is the 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? If you're investing for your young child's education, you'll want the former. If you're looking for a monthly dividend cheque, you'll want the latter. But investment objectives are often vague. That's why you'll want to check out the next section.

2. Strategy

The prospectus also describes the types of stocks, bonds, or other securities in which the fund plans to invest. (It does not list the exact stocks that the fund owns, though.) 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. If the fund can invest in foreign securities, the prospectus says so. Most (but not all) restrictions placed on the fund are also mentioned here, including references to short selling, leveraged purchases, and so on.

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 instance, a prospectus for a fund that invests in emerging markets will reveal that the fund is likely to be riskier than a fund that invests in developed countries. Bond-fund prospectuses typically discuss the credit quality of the bonds in the fund's portfolio, as well as how a change in interest rates might affect the value of its holdings.

4. Expenses

It costs money to invest in a fund, and different funds have different fees but the prospectus should make it easy to compare the cost of one fund with another. Here, you'll find the sales commission the fund charges, if any, for buying or selling shares. The prospectus also tells you, in percentage terms, the amount deducted from the fund's return each year to pay for things such as management fees and operational costs.

5. Past performance

We all know the fund world's catch-all phrase: "Past performance is no guarantee of future results." But a fund's record can give you an idea of how consistent its performance has been. A chart will provide 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.

Some prospectuses include additional return information in the form of a bar chart, which illustrates the fund's calendar-year returns for the past 10 years. This chart is a good way to get a handle on the magnitude of a fund's ups and downs over time. The prospectus may also use a growth of mountain graph or a table comparing the fund's performance to indices 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 people who will be putting your money to work. At this point, many funds identify the name and experience of the fund manager or managers. Also consider the fund manager's tenure—if it's relatively short, the fund's past record may have been achieved under someone else. Find out whether the manager has run other funds in the past. A peek at those funds could give you some clues about the manager's investment style and past success.

Morningstar fund reports
Don't forget, of course, that Morningstar's fund analysts assess a fund's management, its investment approach, portfolio positioning, performance, risk & return, and cost every time they analyse a fund, so it's well worth checking out what our analysts think of any funds you may be considering. Click here to access our fund reports.