Chapter 8
Using Fund Publications
In This Chapter
Understanding prospectuses and annual reports
Checking out the Statement of Additional Information
Fund companies produce a lot of materials. Even with the growth and usage of the Internet, plenty of paper and trees get trashed annually.
While much of what funds publish isn’t worth much of your time, some of it is and can address important questions you may have (or should have) about particular funds. You can learn about fund fees (including so-called hidden brokerage costs), strategies, investment holdings, risks, to name just a few. So, in this chapter, I walk you through three of the most important fund documents published for each and every mutual fund: the prospectus, annual report, and statement of additional information.
Reading Prospectuses — the Important Stuff, Anyway
Securities laws require every fund to issue a prospectus, and the U.S. SEC reviews the details of every single one (which probably keeps plenty of coffee and eyeglass companies in business). A prospectus is usually written and edited by an attorney who wouldn’t know a lively and comprehensible sentence if it clobbered him on the head. You can safely skip most of what’s said in a prospectus, but be on the lookout for a few things you should check out.
The most valuable information — the fund’s investment objectives, costs, and performance history — is summarized in the first few pages of the prospectus. Read these. Skip most of the rest. The rest only tells you more than you could possibly want to know about how the fund is administered. Do you really want to know whether employees are paid monthly or weekly? Which brand of paper shredders they recently bought for the accounting department?
If you find prospectuses to be positively lethal in their tediousness, let me suggest a friendlier alternative: Just jump ahead to the fund recommendations in Chapters 10 through 13 of this book. I’ve already checked them out for you, and they meet the criteria for good funds that I list in this book. However, if you’re going to be assessing funds for purchase other than those presented in this book, you need to be able to read and understand a prospectus.
In the pages that follow, I walk you through the more useful and relevant parts of a well-done prospectus for one of Vanguard’s funds, the Wellington Fund. This fund has been in existence for more than 80 years. Consider that it was launched on July 1, 1929, right before the onset of the Great Depression. So to say that it has stood the test of time and tough times would be an understatement! Since its inception, the Wellington Fund has produced annualized returns of more than 8 percent per year, which demonstrates the value of diversification in stocks and bonds. (Remember, the specifics about the fund have since changed, so be sure to get a new prospectus if you want to invest in the Wellington Fund.)
Cover page
The prospectus is dated (see Figure 8-1) so that you know how recent its information is. Don’t sweat it if the prospectus is several months old; in general, fund companies update prospectuses annually.
Figure 8-1: The Table of Contents shows you what’s covered in the prospectus.
The table of contents is a sure sign that the prospectus is too long — but then lawyers seldom use 1 word where 50 will do. The table of contents helps you navigate the prospectus to find whatever information you want. To illustrate here, I cover a portion of this prospectus (most of the good stuff is near the front).
Some prospectuses describe more than one fund in a particular fund family. (This prospectus covers two different “Share Classes” — “Investor Shares” and “Admiral Shares,” which are identical except that the Admiral Shares have far larger initial investment requirements and lower expenses.) This practice can save a fund company printing and mailing charges when it has funds with very similar investment objectives and/or funds run by the same investment management team.
Fund profile
The fund profile pages (beginning with Figure 8-2) contain a synopsis of the main attributes of the fund, such as a description of the fund’s investment objectives and the strategies (the types of securities the fund invests in) that it employs to accomplish its objectives. The Wellington Fund seeks current income from its investments and modest appreciation. It invests the majority of its assets in stocks that pay decent dividends (for income as well as appreciation potential) and its remaining assets in high-quality bonds (for income).
Thankfully, funds are required to present, in a standardized format, the costs that you’ll incur for the privilege of owning a fund. The first list of expenses shows the fees you pay when you buy and sell shares. These fees are deducted at the time a transaction occurs; unfortunately, they’re rarely itemized. Because a no-load fund such as the Wellington Fund doesn’t charge any sales commissions or redemption fees, you see the word None repeated throughout this section.
Here, you also find a list of the main risks that come with investing in this fund. All funds, especially those which invest in stocks and bonds (as this one does), come with risk. Don’t let this list scare you away — let it make you feel better. You’re hiring a knowledgeable and experienced fund manager who can do a much better job navigating these potential perils than you can.
On the second page of the fund profile section, you find a description of the fund’s performance chart and table (see Figure 8-3). In the chart, you can see the yearly total return that an investor in this fund has earned over the past decade. (Below the chart is a description of the best and worst quarters — three-month periods.) Because this fund invests in a mixture of bonds and stocks, you shouldn’t be surprised to see fluctuations — in some years, you see fairly large positive returns (in some cases, more than 20 percent), and in other years, you see a negative return. The performance information also shows the impact of taxes (which assumes the deduction of taxes at the highest federal rates) and comparison of the fund’s returns to relevant market indexes.
Figure 8-2: The fund summary provides a digest of the fund’s key features.
Figure 8-3: The fund profile summarizes performance data.
If a so-called financial adviser pitches a fund, but you’re not sure whether she gets paid for selling it to you, always get a prospectus and check out the fund expense section. That way, you can see if commissions will erode your returns. In this case, you’d see that if an adviser recommended this fund, she isn’t paid any commission — a good sign. (Refer to Chapter 7 for an example of a typical load-fund fee table.)
Operating expenses are fees charged on a continuous basis by all mutual funds; they cover the expenses of running a fund and include the fund company’s management fee — out of which it earns its profit. In this case, they total a reasonable 0.34 percent (even less for the Admiral shares). Because these fees are deducted from the fund’s returns before your returns are paid to you, lower operating expenses translate into higher returns for you.
In addition to showing you the fund expenses as a percentage of the amount an investor has in the fund, the prospectus also shows you the total expense dollars that an investor will incur over the years by investing a hypothetical amount ($10,000) in the fund.
Other fund information
The next section of the prospectus (see Figure 8-4) presents you with a hodgepodge of facts about the fund, some of which may be important to you: who manages the fund, how long the fund has been in existence, what the fund’s total assets are, what its minimum initial investment amount is, and how to purchase and redeem shares.
Investment objectives and risks
This next section on investment strategies explains in detail what the fund is trying to accomplish and what risks the fund is subject to. In Figures 8-5 through 8-7, I show you the first few pages of this section. The Wellington Fund seeks both moderate growth of capital and current income. It tries to accomplish these objectives by investing in stocks that pay decent dividends and bonds (fixed-income securities). (The Plain Talk sections within this prospectus — see the shaded boxes — explain important fund-investing concepts. The Plain Talk section isn’t required, and you won’t necessarily find it, or the equivalent, in every prospectus.)
Figure 8-4: Important details about the fund.
You can think of the investment policies or objectives as a broad set of rules or guidelines (for example, the major type of securities that the fund invests in) that the fund operates under when investing your money. This hopefully protects you from most major surprises. And if a fund violates these guidelines — for instance, if this fund puts all its money into international stocks — the SEC would spank, reprimand, and penalize Vanguard. Unethical fund companies may be willing to pay this small price if they can seduce more people into their funds by showing higher returns that result from taking poorly disclosed risks.
If you’ve taken the time to look at how much money this fund has made for investors, you owe it to yourself to understand this fund’s risks, too. This section of the prospectus does an excellent job of discussing the Wellington Fund’s risks, using examples from past decades instead of just from recent years, which were generally good years for the financial markets.
Figure 8-5: Investment objectives and risks.
Figure 8-6: More investment objectives and risks.
Figure 8-7: Still more investment objectives and risks.
Investment adviser
This important section (see Figure 8-8) provides background about the investment adviser — the folks actually managing the investments of this fund. You can read about the firm (in this case, it’s an outside money management company — Wellington Management Company) who make the fund’s investment decisions.
Financial highlights
If you get a headache looking at all the numbers on financial pages, you’re not alone. Figure 8-9 looks frightening, but this table is just a yearly summary of the value of the fund’s shares and the distributions the fund has made. (I cover these subjects in detail in Chapters 17 and 18.)
Figure 8-8: The investment adviser actually manages the fund’s money.
Figure 8-9: Financial highlights.
The Net Asset Value (NAV) is the price per share of the fund. Tracking this value provides an incomplete, terrible measure of what you would’ve earned in the fund. Why? Just look at the distributions section, which details all the money paid out to shareholders each year. This fund has paid out total distributions (dividends and capital gains) of $9.63 per share over this five-year period. This per-share figure is an enormous amount when you consider that the share price actually decreased from $30.54 to $28.99 during the period — a 5.1 percent decrease. But if you add in the distributions to the change in share price, now you’re talking about a 26.5 percent (or more) increase (if you’d reinvested these distributions, you would’ve had an even greater return).
The Total Return represents what investors in the fund have earned historically. The returns on this type of fund, which invests in stocks and bonds, bounce around from year to year. You can see how the total investments (Net Assets) in the fund have changed over time. Assets can increase from new money flowing into the fund as well as from an increase in the value of a fund’s shares.
This section of a prospectus also shows you how a fund’s annual operating expenses (Ratio of Total Expenses to Average Net Assets) have changed over time. They should decrease when a fund is growing. This fund’s expense ratio of 0.29 percent in 2005 increased to 0.34 percent four years later. If operating expenses are high (not in this case) and don’t decrease, their persistent levels may signal a company that maximizes its profits because of the fund’s popularity. For funds that are only a few years old, expenses may remain higher because the fund is building its base of investors. (The slight increase for this fund isn’t significant and was due in part to the high return of the most recent year, which increased the fund manager’s performance fee payments.)
The line Ratio of Net Investment Income to Average Net Assets shows the annual dividends, or yield, that the fund has paid. (This figure is especially important for retired people, who need income to live on.) In this example, the downward trend merely reflects the overall decline in interest rates during the period. If you looked at this ratio for a similar fund, you’d see the same trend for this period.
The Turnover Rate tells you how much trading takes place in a fund. Specifically, it measures the percentage of the portfolio’s holdings that has been traded over the year:
A low turnover number (less than 30 percent or so), such as the one for this fund, denotes a fund with more of a buy-and-hold strategy.
A high turnover number (100 percent plus) indicates a fund manager who does a lot of trading. Rapid trading is costlier and riskier and may increase a fund’s taxable distributions.
Reviewing Annual Reports
Funds also produce annual reports that discuss how the fund’s been doing and provide details on the specific investments that a fund holds. Look at the annual report if, for instance, you want to know which countries an international fund is currently invested in.
You can get answers to questions like what countries a fund invests in by calling a fund’s toll-free number or by hunting around on a fund company’s Web site. (Some fund companies enable you to access their fund’s annual reports and prospectuses on their Web site.) Some of the mutual fund information sources that I recommend in Chapter 20 also report this type of information. (Or you could say, “Details, details. Just suggest some funds to buy for different needs.” That’s just what I do in Chapters 11 through 15.)
In this section, I review the pages from the annual report on the Vanguard Wellington Fund — the same fund whose prospectus I introduce you to in the preceding section. In addition to producing an annual report, each fund produces a semiannual report that (guess what?) comes out halfway between annual reports. The semiannual reports are usually a bit shorter than the full-year reports but contain the most up-to-date information on the fund’s current investment holdings and performance.
When you call a fund company to ask for applications, specifically request a fund’s recent annual or semiannual reports. Unlike a prospectus, most funds don’t automatically send you annual reports. (And, of course, most fund companies provide these reports on their Web sites.)
Chairman’s letter and performance discussion
The Chairman’s letter is supposed to explain how well the fund has performed recently and why (see Figure 8-10). In far too many reports, the fund’s chief executive uses his or her letter to the stockholders merely as an opportunity to overhype how well the fund has done — during good periods in the financial markets. In tougher times, too many fund execs blame subpar performance on the market. It’s like fishing: On a successful day, you talk about your uncanny casting ability, your brilliant choice of lures, and your ability to keep still and quiet. When you come home empty handed, the fish just weren’t biting.
Figure 8-10: President’s letter.
A good annual report like Vanguard’s will detail the performance of the fund and compare it to relevant benchmarks and comparable funds. You hope that your fund will meet or exceed the performance of comparable funds (and perhaps even of the benchmark, too) in most periods. Don’t worry if your fund periodically underperforms a little. Especially with stock and bond funds, you invest for the long haul, not just for six months or a year.
Unfortunately, as I discuss earlier in this chapter, more than a few fund companies use benchmarks (indexes) as comparisons for their funds’ performances so that their funds look as if they perform better than they really do. This ruse is similar to a financially savvy adult like, say, me, comparing his mutual fund selection abilities to those of, say, a child. I’m at something of an unfair advantage (at any rate, I’d better be). As you review a fund’s annual report, keep in mind this tendency of some funds to fudge comparisons. In Chapter 17, I discuss ways you can make sure that you’re comparing a fund’s performance to an appropriate benchmark.
In addition to discussing the fund’s performance during the year, an annual report also covers how the overall financial markets were feeling. If you’re used to a steady diet of the daily news, an overview like this can help you to better see and understand the big picture (and maybe you won’t be so shocked that one of your funds lost, say, 2 percent last year when you see that the benchmark index most relevant to that fund lost 5 percent).
A good annual report is educational and honest. As you can see, Vanguard’s is both. The report does a nice job of providing a historical context for understanding this fund’s performance. It also clearly explains that a surging stock market the past year propelled this fund’s returns.
The comparisons to competitors help you make sure that you’re comparing your fund to the Wellington Fund’s true peers — apples to apples. These comparisons are even more valuable and useful when applied over longer periods (see Figure 8-11). You can see how the Wellington Fund performed against its competitors (“average balanced fund”) and the benchmark composite index. The Wellington Fund handily beat the competition and the benchmark index. (The “Composite Index” is a mythical investment, which has the advantage of not having any costs deducted from it.)
In the world of stocks and bonds, one year is too short a period to evaluate a fund. In this section, the chairman also looks forward and prudently reminds you that the future will likely contain both good and bad periods.
Figure 8-11: Long-term performance discussion.
Investment adviser’s thoughts
The “Advisor’s Report” is where the portfolio managers of the fund (in this case, the Wellington Management Company) explain how the economic environment affected the fund’s performance. They also look ahead and discuss what the future may hold and what investment strategy they plan to take in the near future (see Figure 8-12). I especially like how this report highlights not only their successes but also their less-than-stellar performers.
Figure 8-12: Investment advisor’s insights and reflections.
Performance and its components
The performance page looks like a terrible overload of numbers, but it actually contains valuable information (see Figure 8-13).
For example, this table shows you how the Wellington Fund has performed each year. As you can see in the Cumulative Performance table, although the fund has produced an average annual return of 6.20 percent per year over the past ten years, its return varies much from year to year. In 2008 (fiscal year, which in this case ends November 30), for instance, its return was –25.6 percent, but the return was 26.5 percent in 2009. If a swing in returns such as this makes you reach for your motion sickness prescription, you’d better skip investing in the fund.
To earn better returns, you have to take risks.
Figure 8-13: Total investment returns, year by year.
Investment holdings
The Statement of Net Assets section lists every investment the fund owns. Here’s where you get the details that tell you exactly where your money is invested. You can see here the incredible diversification your money gets in a mutual fund; you actually own a tiny sliver of each of these securities if you invest in this fund (see Figure 8-14). For example, in this first section, you can see that this fund (as of November 30, 2009) was 65 percent invested in stocks, which are presented here by industry.
Figure 8-14: Investment holdings of the fund.
Reviewing a fund’s specific investment holdings is important. Sometimes, a fund’s name is misleading relative to what the fund actually holds; often, the Objective section of a prospectus doesn’t provide insight into important factors, such as the sizes of the companies that it owns.
For each security, you also can see how much each investment was worth at the end of the most recent year. (Do you need to know, should you care, and will it be on the test? No, no, and no!)
Continuing on in the report, you see more of the investments that the fund owns. Figure 8-15 shows you some of the bonds the fund owns. These bonds are listed by issuer (government versus corporate) and the corporate bonds by industry and specific companies.
Figure 8-15: Bond holdings of the fund.
Investigating the Statement of Additional Information (SAI)
The brokerage fees that a fund pays to buy and sell securities for the fund are not included in the annual operating expense numbers that a fund reports. Brokerage costs reduce a fund’s returns just the same as a fund’s operating expenses and are ultimately reflected in the fund’s annual rate of return.
Although fund brokerage costs are typically far less than the fund’s operating expenses, funds that frequently trade or “turn over” their holdings can have significant brokerage expenses. These costs are disclosed in a fund’s Statement of Additional Information (SAI). More trades mean more costs draining your returns, which may also lead to more taxable distributions. Rest assured that the funds recommended in this book have relatively low overall expenses including brokerage fees.
In case you’re curious, for the Vanguard Wellington fund, the brokerage expenses amount to about 0.07 percent annually — a small fraction of the funds’ annual operating expense ratio.