How to Analyze a Prospectus

If your eyes tend to glaze over when you review a prospectus, you’re in good company. The sheer size of some prospectuses and the legal jargon contained within them is often daunting to seasoned investors as well as novice investors. But it may help to know that if you familiarize yourself with certain key points, you may not have to get bogged down in every little detail. Even if you’re not a financial wizard, you can learn how to analyze a prospectus and extract the pertinent facts that help inform your investment decisions.

A Prospectus in a Nutshell

A prospectus is a report that offers a comprehensive overview of certain investments. Some of the topics covered in a prospectus include past performance as well as future projections for the entity that issues the prospectus. A prospectus also provides an outline of the investment's management and lists the fees that potential investors incur. Management information includes the investment adviser, also referred to as the management company or the investment manager, and the portfolio managers, who are typically listed by name plus title, depth of experience and length of time spent with the investment adviser.

The Purpose of a Prospectus

Although a prospectus provides existing investors and potential investors with lots of information about an investment vehicle, its primary purpose is to provide transparency about the possible risks of the investment. Putting these risks on the table helps protect investors against uninformed investing decisions that may not be right for them. Disclosing these risks also protects the issuing entity from a potential legal backlash because of misleading or withheld information.

Who Issues a Prospectus?

Legal entities that develop, register and sell securities to finance their operations are legally required to issue a prospectus. Issuers include companies, corporations, investment trusts and even governments (domestic and foreign). Securities include stocks, bonds and mutual funds.

Who Mandates a Prospectus?

The U.S. Securities and Exchange Commission (SEC) requires legal entities that sell securities to file a prospectus. But each entity cannot simply devise its own prospectus format. The SEC also establishes guidelines for the information that must be included in each prospectus.

Furthermore, a prospectus for an investment offering may actually be comprised of two parts. These include the preliminary prospectus, which provides details about the issuing entity and the specific investment transaction, and the final prospectus, which includes back-end details such as the number of shares or certificates issued and the exact offering price.

Analyzing a Prospectus

As you begin to analyze a prospectus, look at the categories of information that the SEC requires issuing entities to provide. Each of these categories can help walk you through a flow chart of sorts to determine if the investment is a good fit for you. The SEC offers online help for analyzing mutual fund prospectuses. If you visit Investor.gov and enter “how to read a mutual fund prospectus” into the search box, you’ll discover a three-part investor bulletin series published by the SEC.

Prospectus Investment Objectives

Typically, a prospectus investment objective includes capital appreciation, income or both. If the investment goal is capital appreciation, the funds are predominantly invested in assets that the fund anticipates will increase in value. If the investment goal is income, the funds are mainly invested in securities such as interest-yielding bonds or dividend-yielding securities. If the investment goal is a combination of income and capital appreciation, the funds are typically invested in a combination of bonds and equity securities.

Prospectus Investment Strategies

After you’ve reviewed the investment objective of your prospectus, look at the investment strategies – ways the issuing entity plans to reach its objective. These strategies include how the investment manager decides on specific securities to buy and sell, which may be divided by industry, type of security or geographic area. The SEC cautions against relying solely on a fund’s name to determine its investment category without also delving into the prospectus for a specific description.

Prospectus Risk Assessment

This step in your analysis fulfills the primary reason the SEC requires a prospectus – identifying and analyzing your investment risks. Although all investments carry the potential for financial loss, not all investment vehicles lay the cards on the table for identifying these risks. So if you’re looking at a prospectus, you’re more equipped to make your decision than if you’re considering an investment that does not offer a prospectus. Ideally, the investment objective and risk assessment of a prospectus mirror your own investment objectives and risk tolerance.

• Market risk. Markets fluctuate. Look to your prospectus to identify the risks that apply to the fund-specific market or markets that apply to your investment.
  
• Business risk. The SEC reminds investors to take a good look at companies without established track records, or companies that are experiencing financial difficulties.
  
• Credit risk. You’ll face a credit risk if you partner with companies that invest in debt instruments issued by another company that cannot make the interest payments on time – or even the repayment of principal.
  
• Interest rate risk. The return on your investment in debt instruments will decrease with declining interest rates, which is a consideration to factor in your investment decision.
  

• Inflation risk. The inflation that an economy experiences can put investment pressure on the debt instruments in your portfolio. Over time, an inflation risk you take is the possibility that your fund’s value can’t outperform inflation prices.

• Concentration risk.

  You’ll choose whether your investment portfolio is concentrated or diversified. A concentrated portfolio has a narrower focus on the type of its investments than a diversified portfolio. The narrower your portfolio’s concentration, the more volatile your investment may be when compared to putting your investment eggs in more than one basket to diversify your portfolio.
  

If you're simply scanning a prospectus, you may see risks addressed early in the document simply as a cursory overview. But keep flipping through the prospectus to find the section that details the fund risks.

Prospectus Fee Review

A fund with high fees is not necessarily a deal-breaker as an investment, but you’ll want to make sure that you’ll have a higher return on this type of investment than another investment vehicle with lower fees. The SEC requires prospectus issuers to provide a standardized presentation of fees to give investors an easy comparison of fees among different investments. A prospectus includes two types of expenses – shareholder transaction expenses and annual fund operating expenses – plus a hypothetical example of how these expenses affect your investment over different time periods.

• Shareholder transaction expenses. Some investment funds include commissions or "loads," which are fees paid to the investment professionals who sell the fund to you. Other funds are "no-load" funds, which you can purchase without an investment professional and do not have commission fees. Be on the lookout for other costs such as maintenance fees, which you may have to pay if your account balance drops below a minimum requirement.
  
• Annual fund operating expenses. These costs are also called the "expense ratio" because they represent the percentage of assets that the fund uses each year to pay for certain expenses. For example, these fees may include management fees, which pay the investment adviser for managing the fund, making investment decisions and providing other services. "Rule 12b-1" fees pay for sales and marketing costs. Miscellaneous operating expenses may include legal fees, transfer fees and auditing fees.
  
• Hypothetical example. Hypothetical examples translate percentages and ratios into actual dollar amounts to illustrate how, for example, a $10,000 investment performs over periods of one, three, five and 10 years. The example shows the outcome of an investor holding the investment for the duration or redeeming the investment at the end of each period. The hypothetical example also illustrates the financial impact of operating expenses and other fees on your investment.
  

As a rule of thumb, high fees for mutual funds typically exceed 1.5 percent, and low-cost funds typically have fees that are below 1 percent.

Prospectus Past Performance

The past performance of an investment fund is not a guarantee of its future performance. But when you analyze trends over time, you may see patterns emerge, which may be helpful in making your investment decision.

Look for these three illustrations of past performance as you analyze a prospectus:

1. Bar chart. When you analyze a fund by viewing a bar chart of its performance, you’ll get an at-a-glance picture of its up-and-down fluctuations. The bars on the chart may drastically fluctuate, which could indicate a measure of investment volatility, or the bars may hold fairly steady, which could indicate consistent returns on investments.
   
2. Comparison table. Unlike a bar chart, which graphs only the performance of the prospectus fund, a comparison table typically compares the prospectus fund against a bigger market, which is represented by the market index. However, if a fund adviser deems a narrower market more representative of the fund’s performance, the comparison table may include a narrower-based index.
   
3. Performance by quarter. The performance part of a prospectus includes the fund’s best and worst performing calendar quarters so you can analyze its volatility.
   

Where to Get a Prospectus

The SEC requires issuers of securities to provide a copy of the prospectus before (or when) issuing shares of the fund to its investors. But if you’re not currently an investor, you may be able to find a prospectus by visiting the company’s website. Most fund websites either post its prospectus or provide a telephone number for you to call and request a copy. You can also access the SEC’s EDGAR (Electronic Data Gathering, Analysis and Retrieval) database to view or download a prospectus. Visit Investor.gov, type “EDGAR” in the search box and follow the prompts to find this feature.

If you receive a short prospectus of only a few pages, it's likely a "summary prospectus." But contained in the summary prospectus you'll find where and how to obtain the complete prospectus.

Keeping It Current

A fund's prospectus isn't a one-time publication. The SEC requires periodic updates to provide investors with current information. For example, mutual fund prospectuses must be updated yearly, or more frequently if a fund experiences a significant change such as a change in management or administration.

Financial Planning Advice

Even seasoned investors can get lost in the legalese of prospectuses. Whether you're a seasoned or novice investor, seeking advice from your financial planner may go a long way toward making an informed investment decision. Your financial planner may also be able to provide you with copies of prospectuses to save you time in searching for potential investment candidates.