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How -- and Whether -- to Read Your Prospectus

I'll let you in on a dirty little secret.

There's something I'm really supposed to do that I don't.

At my portfolio's peril, claim the finger-wagging experts, I don't read the prospectus. At least not cover-to-cover.

And I bet I'm not alone. C'mon -- admit it. Do you glance at the garble of dense legalese, then guiltily file that prospectus away in your "To Do" folder, where it will never surface again?

In fact, these documents are not intended to educate investors; instead, they're designed to protect the issuers. I think of them not as the ABCs of a mutual fund, but the CYAs. Lawyers throw in every bit of boilerplate imaginable. And that leaves a big job for us: sifting out the good stuff from the gobbledygook. Because there actually is very important information hidden among the herebys and therewiths -- you just have to know where to find it.

Perusing the Prospectus

Here are the highlights I hit, my one-minute guide to your mutual fund prospectus:

Investment Objective

You want to know your fund's goals and how it will achieve them. Here, you'll find out the basics, but don't expect an in-depth description. Look to see whether a fund can invest in stocks and bonds, or both, and in what combination, or if the manager has an eye on international as well as domestic equities, or large- as opposed to small-cap stocks.

I usually don't depend on this section to tell me much more than that. There can be a huge disconnect between what a fund is allowed to do according to its prospectus and how the manager really invests. Remember that the prospectus is almost always written to give the manager maximum leeway.

The Expense Table

This is one of the most important parts of the prospectus. It is the fund's "price tag," and although it's not as easy to understand as the ones you'll find on your supermarket shelf, the expense table is key investing information. That's because an easy way to boost your returns is by choosing a fund with low expenses.

First, check for any sales commissions, also known as loads. Then size up the expense ratio. That's the percentage of a fund's assets deducted each year for expenses. It includes management fees, which all funds charge to pay for the basics of business, like overhead, manager salaries and research.

You may also find a 12(b)-1 fee, ranging from 0.25% to 1% -- about half of all funds charge shareholders annually for marketing and distribution. But sales charges and redemption fees, or brokerage fees and other direct trading costs, are not reflected in the ratio.

If you understand dollar amounts better than percentages, you'll find an expense table that shows how fees will affect the value of a $1,000 investment, assuming the fund returns 5% a year.

But these numbers won't mean much to you without some context. The average expense ratio for all equity funds is 1.44%, yet you'll want to compare yours to the average of the fund's peer group. (Click

here for my column last week, which offered an in-depth explanation of mutual fund fees and a table listing the average expense ratios for most fund categories.)

Financial Highlights

Here, you'll find how a fund performed for the last few years. But don't stop there! Although returns are what matter most to your bottom line, there are several other important numbers in this section that may have an impact on how your fund will perform in the future.

Because size can be a drag on performance (can you say "

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Magellan?"), I like to see how big the fund is and check the "Net Asset" line to see how quickly it has grown.

I also look at portfolio turnover -- that is, the annual rate of a fund's buying and selling activity, how much of the portfolio is "turned over" or changed. A turnover rate of 100 means the manager "turned over," or changed, all the portfolio (or that 1% was traded 100 times, or 25% traded four times, or he left half alone and changed the other half every six months).

Higher turnover usually means greater brokerage costs. Also, if the manager makes money on the trades, he is building up "realized capital gains," which may mean a higher tax bill at the end of the year for you. But be careful in interpreting turnover. A high number is not necessarily a bad thing. Some managers are great traders and use trading strategies to your advantage.

Except for the real basics, such as the minimum investment, that's about it for the prospectus. Of course, some are more worthy of your time than others.

John Hancock's

, for example, have a reputation for being written in (gasp!) easy-to-understand English.

The

SEC

plans to require all companies to comply with basic guidelines of good writing by the end of the year. But, as you'll see in a moment, the main issue isn't so much how a prospectus is worded, but what is in it -- or, more importantly, what is NOT.

Reading the Annual Reports

Annual and semiannual reports may not compete with

John Grisham

on your reading list, but at least they are more interesting and informative than prospectuses. I always look at the "Investment Portfolio" section to see a list of holdings and sector allocation. But remember that by the time these reports reach you, the inventory may be quite out-of-date for some funds.

You can't count on knowing what

Ken Heebner

is investing in by reading his annual report, for example. The "Mad Bomber" has a well-deserved reputation for trading fast and often.

I like annual reports mainly because this is the manager's chance to communicate directly with you about what has happened to the fund in the last twelve months. Many offer candid appraisals of how they're doing.

I want a manager who will tell me he screwed up and why. Is he honest enough to say why he's lagging the benchmark? I also like a manager who's on a streak but isn't afraid to warn that those winning ways won't last forever.

Vanguard

can always be counted on for a straightforward assessment of double-digit returns.

As soon as CEO Jack Brennan found out that the very-hot

S&P 500 Fund

was synonymous with "safe and guaranteed" in many novice investors' minds, he wrote about the risks of indexing. I also appreciated the cautious prediction of

TheStreet Recommends

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Oakmark Select's

Bill Nygren

(a fund I

profiled last month) that his sizzling short-term numbers (up 55% last year) could not be sustained.

Annual reports also offer a window into the investing strategy of Wall Street's smartest minds.

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Third Avenue Value's

Marty Whitman

(click

here for my profile of him) takes great pride in his investor literature, providing annual reports that are among the best in the business. Whitman's most recent is almost a textbook in investing in the Japanese insurance industry.

It's clear

Tweedy Browne

takes writing these reports seriously as well. The company delayed publishing last year's annual report to include advice to worried investors about how it intended to handle the turmoil in the wake of the Oct. 27 crashlet.

But entertaining and educational as these reports often are, they, too, do not tell the whole story.

Shhhhh! What You Won't Find in Fund Literature

Here are just a few questions you need to consider when buying a fund. Don't expect to find the answers in either your prospectus or annual report:

How does a fund compare with its peers?

You likely won't find an answer, unless, of course, a fund is doing better than the average. You're left to check outside sources such as

Morningstar

and

Lipper

for those numbers.

here for my explanation of common measures.) The SEC toyed with the idea of forcing fund companies to include some assessment of risk in fund literature, but it soon dropped this tough and controversial issue.

How did the fund perform in down periods?

One of the best ways to judge a fund is to isolate its performance in down periods or bear markets. Call a shareholder rep and ask him about the fund's performance for a time period that concerns you, like last quarter, for example.

Who serves on the board of directors?

You won't find the names of the men and women responsible for overseeing your fund unless you request a "Statement of Additional Information." But it's good to know, because, in what seems to be an obvious conflict of interest, the board's chairman and directors are sometimes part of management. Not surprising, then, that such items as fee increases or other items on management's agenda often get rubberstamped.

Does the manager personally invest in the fund?

Putting your money where your mouth is means a lot. Ask the shareholder services rep the question, and read articles like the ones on

TSC

, which often address that question.

* * * * *

Now you can see why I don't waste much of my time reading the official literature. I'm too busy trying to figure out what's really important. And if you peruse the prospectus and annual report only, you simply do not find the information you need to make an informed investment decision.

That's the really dirty secret.

Readers Chime In

Several

TSC

members weighed in with their fave fund writers, managers whose annual reports stand out:

"James Gipson's epistolary offerings won me over to Clipper. Why shouldn't my brain be delighted along with my wallet?"

-- Ainslie Baldwin

Peter Holstein is another "Marty maniac." "Whitman's Third Avenue Value reports have become must-reads. He basically authors a brief textbook on his style of value investing. Awesome stuff."

Brenda Buttner's column, Under the Hood, appears every Thursday on TheStreet.com.