A prospectus is intended to give you as an investor the information you need. It is also a legal declaration that protects the issuer, who provides information required by the Securities and Exchange Commission to ensure that investors are not misled in any way. Your goal is to wade through the standard legal terminology and distinguish between what would appear in any prospectus and the statements that tell you something unique about the mutual fund or company.
How to read a mutual fund prospectus
A mutual fund's prospectus describes the fund's objectives and the securities it invests in. The name of the mutual fund can be revealing, but you should check out the objectives and strategy to find out its goals.
You'll also want to pay careful attention to the types of securities (stocks, bonds and money markets) that the mutual fund invests in. Generally speaking, you want stocks for growth, bonds for income and potentially reduced volatility and money markets to potentially protect your investment growth.
It's important to match the investments a mutual fund holds to your investment needs and risk tolerance. Specific information about risks will be spelled out in the prospectus, along with information on how the fund managers attempt to manage risk. For some mutual funds, this could mean shifting a large percentage of assets from stocks to bonds or vice-versa, which could make these funds incompatible with your investing needs.
To see how the fund has been doing, search the prospectus for the bar charts showing the fund's returns over the past 10 years. There will also be a table showing the fund's annual average return, before and after taxes, for the past 1-, 5- and 10-year periods. By comparing the charts in several prospectuses, you can see how similar mutual funds have performed, but remember that past performance is no guarantee of future results.
Fees and financial highlights
A mutual fund prospectus outlines the fund's fees, including management fees, other operating expenses, redemption fees and any 12b-1 fees to cover marketing. You will see a table showing your hypothetical total expenses if you were to invest and hold your investment over 1-, 3-, 5- and 10-year periods.
The financial highlights in the prospectus contain condensed, audited data on the fund's performance for the past five years. This includes net asset values, investment income, dividends and distributions, the ratio of expenses to average net assets, the ratio of net income to average net assets and the portfolio turnover rate.
How to read a stock prospectus
The Company and Business sections of a stock prospectus describe the company's history, products, business plan, strategy and principal competitors. This is especially important when the company is a newcomer taking on a large competitor that has dominated the market.
The company makes forward-looking projections in its analyses and discussions. The prospectus cautions you about relying on statements including words such as "anticipate," "believe," "estimate," "expect" and "intend." These forward-looking statements are projections and actual results may be significantly different.
Projections contain inherent risks and uncertainties and are no guarantee the company will meet its targets. The risk factors identified in the Certain Considerations section of the prospectus will help you determine whether the forward-looking statements seem realistic.
Look for any good or bad news in the Recent Developments and Litigation sections of the prospectus. The management discussion and analysis is an excellent place to get insight. Management discusses how it has performed, describes trends and explains where the company is heading with this capitalization.
The prospectus also lists the directors and executive officers and their experience, which should be extensive in the company's line of business. Note any special stock option plans or rights for management or employees. These plans provide performance incentives, but they may reduce dividends significantly.
Crunching the numbers
The financial statements and notes at the end of the prospectus are where you can sink your teeth into the details. Look at the balance sheet to see how financially solid the company is, noting the company's revenues, expenses and bottom line in the income statement.
The cash-flow statement shows sources and uses of cash, broken down into operating, investing and financing activities. Note any significant variations from one period to another. Sort out large unusual events and their impact on earnings to determine the future earning capacity of the company.
Search the capitalization table in the prospectus for footnotes on common-stock equivalents that, if converted, could depress the price of your shares. The bigger the pool of outstanding stock, the greater the amount of earnings needed to maintain or increase the share price. The Dilution section compares tangible book value with the offering price, essentially the price-to-book ratio.
The Notes in the prospectus contain breakdowns of many of the items in the financial statements. They also disclose pending litigation, contingent liabilities and commitments. Watch out for unexplained changes in accounting methods that may be intended to make things look better than they really are.
The prospectus also includes the opinion of independent auditors who have reviewed the statements and the company's books. Look for "present fairly." Any qualification suggesting the company may not be a "going concern" is serious and should send you looking for other investment options.
In the Principal and Selling Shareholders section, you can see what other shareholders are doing, before and after the stock offering. This tells you whether they feel it is worthwhile to keep their stock. Many insiders unloading their stock may be a red flag.
Certain Transactions discloses related-party transactions. Keep an eye out for loans, less-than-competitive sales or acquisitions and service contracts substantially above or below market value. Sometimes called sweetheart deals, these arrangements may siphon capital out of the business.
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