Mutual Fund Prospectus, SAI, Shareholder Reports

To REALLY understand mutual funds--and investment vehicles in general--download a mutual fund prospectus, and an SAI, and a shareholder report. If you want the scaled-down, bare-bones disclosure document, download the prospectus or the even slimmer summary prospectus. You'll find the risks and objectives and policies of the fund, the fees and expenses, the taxation issues, etc. But if you want to see precisely what's in the portfolio, download the statement of additional information or SAI. For example, when I look at the prospectus for the American Balanced Fund, I see that: "The fund invests in a broad range of securities, including common stocks and investment-grade bonds (rated Baa3 or better or BBB- or better by Nationally Recognized Statistical Rating Organizations designated by the fund’s investment adviser or unrated but determined to be of equivalent quality). The fund also invests in securities issued and guaranteed by the U.S. government and by federal agencies and instrumentalities. In addition, the fund may invest a portion of its   assets in common stocks, most of which have a history of paying dividends, bonds and other securities of issuers domiciled outside the United States." Okay, that's a good general statement that could attract or repel from an investment in this conservative mutual fund. But if I'm willing to download the statement of additional information/SAI, I can get more detail on the portfolio. For example, I see that within the 69.73% of the portfolio devoted to common stock, there are some 45,386,600 shares of Wells Fargo worth at the time $1.25 billion. The portfolio holds 16 stocks in the "financials" sector, which represents both 10.8% of the fund's industry allocation and approximately $5.3 billion of market value.  By the way, I notice that this mutual fund holds large positions in at least four other companies that issue and/or manage mutual funds. Hey--why not--it's a great business? So, the SAI gives a much more detailed look at the mutual fund portfolio than the prospectus or summary prospectus.  If I want to know that and also how much money the fund pays in expenses to all the various service providers, I need to download the shareholder report--either semi-annual or annual. In this report, I discover that the following parties were paid the following amounts:
  Investment advisory services   121,350,000
  Distribution services  182,738,000
  Transfer agent services  42,807,000
  Administrative services   30,064,000
  Reports to shareholders  2,393,000
  Registration statement and prospectus  762,000
  Trustees’ compensation  458,000
  Auditing and legal   133,000
  Custodian   278,000
  Other   2,214,000
TOTAL EXPENSES $383,197,000

So, the fund's income statement shows that the portfolio earned $1,306,571,000 in dividends and interest, and after deducting $383,197,000 for expenses, the net investment income was $923,374,000. Notice that the adviser earned about $121 million managing the portfolio; the distributor earned about $182 million marketing the shares and providing other services. Heck, just generating the semi-annual and annual reports themselves cost about $2.4 million a year! In any case, I find this stuff interesting. It's painful to dig in at first, but the rewards are pretty high. I mean, if you understand mutual funds to this level, how hard are the test questions really going to be?

What the heck is a mutual fund anyway?

The last post drew a comment from a long-time reader of this blog. Rather than answer the question in the comments section, I thought I would use it for a blog post. Daniel is now in the business and asks me the following question:

How can I define/describe mutual funds to a "normal" person? I know the financial definition of it, but I can't seem to reword it properly.

RESPONSE: I would tell investors first that they could always purchase shares of stock or individual bonds all by themselves without going through a mutual fund. Trouble is, if they only have a few hundred or a few thousand dollars, they will not be diversified that way, and it is very inefficient to purchase less than $100,000 worth of bonds due to the high markups or commissions that brokers charge. Rather than invest a few hundred or thousand dollars into just a couple of stock issues or one bond issue that could easily end up defaulting, most investors prefer to buy shares of a portfolio that is already diversified and run by a team of professional investors. We call these portfolios "mutual funds" because each investor mutually owns his percentage of each security in the portfolio. Now, a few hundred or a few thousand dollars can be invested and provide the investor with immediate diversification--it is safer to own little pieces of, say, 100 different stocks or bonds, versus putting all the money an investor has to invest into just a couple of stocks or bonds. Also, a mutual fund investor can liquidate some shares without losing the diversification he enjoys. If he, on the other hand, owned shares of stock, he would have to decide which issue to sell, and if he liquidated all of his GE, his diversification would be lost. In exchange for the diversification and the professional management mutual fund investors sometimes pay sales charges to buy or sell the shares and always pay expenses (management fees, 12b-1 fees usually, and other expenses). If the expenses are reasonable, it's a fair bet that most investors are better served through mutual funds as opposed to trying to pick stocks and bonds on their own.

In the textbooks I often describe a mutual fund as a big "portfolio pie" that serves up as many slices as investors want to buy. Every investor mutually owns his percentage of the portfolio pie. If the ingredients of the pie go up in value, so does the value of the investor's holding. If the ingredients (stocks and bonds) pay dividends and interest to the portfolio, that also makes the slices owned by the investor much sweeter/more valuable. If investors want to turn their slices of pie into cash, the mutual fund will do so any day the markets are open. There's no guarantee as to what a share will be worth on any given day, but that's always true of the investment world.

Sales Charges vs. Operating Expenses

Sales charges and operating expenses are two different things. Sales charges are an extra fee added to the price of mutual fund shares when the investor purchases them. They go to the underwriter and the broker-dealers and agents in the distribution network. Sales charges cover the costs of printing the prospectus and other sales literature, sending it out in the mail, paying agents and broker-dealers to sell the shares, and doing all the advertising that we see in magazines and hear on the radio these days. Do all funds have sales charges? No. The ones that do not impose sales charges are called "no load" funds. But, whether there is a "load" or not is one issue. The other issue is this: all mutual funds have operating expenses. Management fees cover the investment adviser who trades the portfolio. Accounting, legal, consulting, board of director and other expenses are usually lumped under "other expenses" in the prospectus. And, even though the fund calls itself "no load" it can still tack on another operating expense called a "12b-1 fee" that covers the costs of distributing/marketing the fund shares. The 12b-1 fee can not exceed .25% of the average net assets, but as long as it doesn't, the fund can call itself "no load." So, not all funds have sales charges, but all funds impose operating expenses. Many people think they don't pay ongoing fees to hold their fund shares, but that' s because they don't get a bill. The fund just reaches into the big cash register and pulls out enough cash to cover the operating expenses mentioned above. Again, sales charges are not operating expenses. They are tacked onto the price of an A-share when the investor purchases or subtracted from the proceeds of a B-share when the investor sells. Either way, the fund takes out operating expenses along the way, including the management fee, the 12b-1 fee, and all "other expenses."

Mutual Fund A, B, C Shares, UITs, etc.

When you recommend mutual funds to investors, part of your suitability obligation is to help determine the proper share class. An investor with, say, $100,000 and a long time horizon should be purchasing A-shares. She will knock down the front-end sales charge with her quantity purchase, and her expenses going forward will be significantly lower than on B- and C-shares. B-shares are suitable for an investor with a long time horizon and a smaller amount to invest. This investor will avoid the front-end sales charge, and as long as she holds the shares 6 or 7 years, the back-end sales charge will go away, and then her shares will convert to A-shares with their lower operating expenses. She will pay higher operating expenses, but due to her small amount of $ to invest, she couldn't reach a breakpoint on A-shares, anyway. This is her best option. C-shares charge high operating expenses, and, unlike B-shares, these things do not convert to A-shares. So, they are generally for investors with a short time horizon. We don't want to keep hitting them with high annual expenses for very long, but if the investor will only hold the shares, say, three years, C-shares are ideal. No need to hit her up with a big front-end sales charge if she's only going to hold the fund a few years. As long as the investment is under, say, $500,000, C-shares will be suitable for a short-term investment. And that implies that a larger investment--even over the short-term--would be more suitable in A-shares, since the front-end load would be knocked down so low and then the investor would also enjoy the low operating expenses going forward. In other words, it's freaking complicated. And that's why many firms end up getting fined millions of dollars and returning millions of dollars to over-charged customers. They don't have adequate training and supervision in place. The rep's don't know enough about the various share classes, or maybe--just maybe--they prefer making the highest compensation possible, regardless of what's best for the customer. When you read the news release at the link below, please know that I am absolutely not bashing Wachovia here--heck, I'm a Wells Fargo shareholder (they own them now), and I also sell a lot of Pass the 65 and 66(c) books, DVD's etc. to Wachovia employees all across the country. Every firm out there could provide us with dozens of similar fines and mishaps--the securities industry is complicated. No one can stay on the right side of the regulatory line all the time. I don't see a need to explain the UIT angle, since the FINRA news release does such an excellent job of bringing up the testable points. Check out the news release at :
http://www.finra.org/Newsroom/NewsReleases/2009/P117836