Read the prospectus carefully before investing. Sounds familiar, right? But exactly how do you "carefully" read a fund prospectus?

Whether you're about to buy shares of a mutual fund or an exchange-traded fund ( ETF), or you need to decide what to do with a fund investment that you currently own, you should definitely take the time to parse the prospectus. But sifting through that monster document can be a time-consuming challenge, so here is an A to Z guide to help you get the information you need and point out the material you can skim (or even skip).

What's a Prospectus?

A prospectus is a document that a company uses to describe its mutual fund or ETF that it is offering to the public. Prospectuses are chock-full of information, from how the fund will invest to how it has performed historically. Although this guide will only look at fund prospectuses, it's important to note that when a company goes public (see IPO) it is also required to file a prospectus.

So where can you get a prospectus? The easiest way is to simply contact the issuer. Call up any large investment management firm like Vanguard, T. Rowe Price, or iShares (Barclays), and they'll be glad to mail out a prospectus to you. Alternatively, most investment firms make prospectuses available on their Web sites as well.

So here is your A to Z guide to things you should consider when you read the prospectus of a fund that you're interested in.

A: Assets

Stocks? Bonds? Large-caps? One of the most fundamental questions about any mutual fund or ETF is "What kind of assets does the fund hold?" As with your personal portfolio (see Allocate Your Assets Like a Pro), the way a fund's assets are divided by class (like equity, fixed income and cash equivalents) can have a lot to do with the risks and returns associated with that fund. So understanding exactly how a fund is broken up should be one of the first things you check in any prospectus.

Because of its importance, you'll typically find this kind of information at the beginning of the prospectus, in the section explaining the fund's "strategy." The fund's specific holdings (or where to find them) will also be explained later on in the prospectus (see F: Financials).

B: Buying Shares

When it comes to buying shares of a mutual fund or ETF, "some restrictions may apply." That's because many funds have minimum initial investments as well as restrictions for buying additional shares. However, this is much less of a problem for ETFs, where you can begin investing with only one share. Generally speaking, buying restrictions will be toward the middle or end of a fund's prospectus. We'll take a look at selling in a little bit.

C: Charts (and Tables)

If you find a chart or table that catches your eye, let it. There's probably a good reason that graph was included in the prospectus. But keep in mind that not all charts or tables are created equal. It's easy to skew the appearance of a graph by playing with scales, so make sure you look at the actual numbers, not just how high that bar (or line) for this year's gains are compared to five years ago.

D: Distributions

Distributions, or "payouts" to investors, should definitely be on your fund radar. Early on (typically in its own section) in the prospectus, you can learn about your mutual fund or ETF's policy on distributions to shareholders. This policy will answer important questions, such as "Will the distributions be paid out by check?" and "Will they be reinvested?"

E: Expenses

The bane of investors, expenses are likely one of the most important parts of a fund's prospectus. Like distributions, expenses are important enough for their own section early on.

For mutual funds, the expenses section will explain whether or not the fund is a load fund (that charges a sales commission), or no-load fund (no sales commission), and whether it charges a 12b-1 fee for marketing the fund. The average expense ratio on an actively managed mutual fund currently hovers around 1.5% (ETF and index fund expense ratios are typically lower), and includes "overhead" like management paychecks (which can be up to 1% of assets) and administrative costs (0.1% to 0.4% of fund assets).

High expenses don't necessarily suggest increased performance (see "Busting the Mutual Fund Myth"), so be vigilant in choosing funds that don't charge you an arm and a leg.

Before we exit the topic of expenses, let's not forget about taxes. Mutual fund taxes can be tricky. That's why they're typically addressed in their own section of the prospectus. The tax section should let you know about tax procedures for distributions as well as how you'll receive tax forms and other information you'll need to file your taxes come year-end.

Your taxes should be a part of your decision to sell. With capital gains taxes lowered until 2011, people will likely be a lot more prone to sell off juicy positions in the next few years. Long-term capital gains taxes (those on investments held more than one year) are also low for the time being at 5% to 15% depending on your tax bracket (though some real estate gains can be taxed at 25%).

Given the U.S. tax system, selling off the same investments in one year vs. another can result in a substantial difference in what your bank balance shows.

(For more information on gauging fund expenses, check out "A Better Way to Pay for Your Mutual Fund.")

F: Financials

The financials in a mutual fund or ETF's prospectus typically include a few of the things you'd find in a public company's financial statements (like net income and assets) as well as the ratios covered in this guide (like expense ratios and turnover), and anything else the fund's management thinks would help inform your investment decision, including things like who the fund's auditors are.

Depending on the fund, the holdings of the mutual fund or ETF will also appear in the financials section. Index funds may simply refer to the indices that they mirror (see passively managed), while actively-managed funds might explain where up-to-date holdings can be found.

Overall, the presentation of financial information in the prospectus can vary quite a bit from one fund to another. Remember, the prospectus is a big, all-encompassing document that probably doesn't have room to get into too many specifics.

If you're really interested in the financials of a particular fund, other filings like a mutual fund's N-Q (more on that later), or an ETF's unique financial statements might be more enlightening in that they can provide a lot more depth than the prospectus has room to offer.

G: Gains (and Losses)

Is the fund principally interested in quick capital gains? Or, is it focused on long-term appreciation? Questions like these are something that you'll find out about in the beginning of the prospectus, under the fund's strategy.

While you're thinking about the fund's performance, it couldn't hurt to think about how that performance might translate into your personal capital gains (or losses) and the taxes that come with them.

H: Holding Your Investment

"For funds with a 365-day holding period, a redemption fee will be charged on shares sold before the end of the required holding period." -- T. Rowe Price Blue Chip Growth Fund

Did you know that how long you hold onto your fund can have a big impact on how much money you make? In the prospectus for their Blue Chip Growth Fund, T. Rowe Price explains the consequences of not considering your holding period.

If you're not selling off your stake (or at least not all of it) in a particular mutual fund or ETF, the fund's prospectus will provide you with any rules that may apply to holding onto your investment. Information on redemptions, reinvestment and obtaining shareholder reports can all be found toward the end of the prospectus.

I: Income

Many funds receive substantial amounts of income from their investments in the form of both interest (fixed-income) and dividends (equity). What the fund will do with this money can usually be found in the investment strategy section.

J: Junk and Jargon

One of the less scientific measures of a fund's health can be the amount of "junk and jargon" that fills its prospectus. Let's face it: Litigious and complicated wording can do a good job of hiding important information. The readability of the prospectus is paramount. And while it is a legal document -- and should sound "professional" -- plain English explanations of strategies and fee structures offer you a level of transparency that's definitely desirable.

K: Know the Company

Who is the fund issuer? What do you know about them? Investment management firms like Fidelity, Vanguard, T. Rowe Price and Barclays have gained the public's trust through decades of making money for them. If you're not familiar with the issuer of your fund, should you be worried? Read the prospectus first.

You'll find the issuer's name plastered throughout the prospectus. Established and reputable companies often highlight a few key facts about their business and history at the beginning of the prospectus (as an example, T. Rowe Price is quick to point out the fact that it manages over $330 billion in assets).

L: Liquidity of the Fund

Liquidity, or how easily convertible a fund's assets are to cash, is definitely of concern for investors. Of late, we've seen what a dramatic impact a lack of liquidity can have on our investments (see "Fickle Market Ends Mixed"). You can get clues about the fund's potential liquidity by looking at its investment strategy.

You should look out for strategies that don't match the liquidity you'd like to see in a fund. And while the prospectus will point out the liquidity strategy the fund is going for, more timely tools (see Q: Quarterly Reports) will give a more up-to-date view of the fund's actual liquidity.

M: Management

Who actually runs the fund that you're interested in (or currently own)?

The fund manager plays an integral role in the performance of your fund -- so much so that some really successful managers are practically considered celebrities in the investment world (on the other hand, see "Why Pay Your Manager for Doing Nothing?").

In addition to the fund manager, a fund will have a board of directors that makes the really big decisions for the fund. The exact details of the fund's management structure will be laid out in the "Management" portion of the prospectus.

N: Net Asset Value

Net Asset Value ( NAV) for a fund is the total value of the fund based on the prices of the stocks, bonds and/or other securities it holds. It stands to reason, then, that the NAV is essential when it comes to pricing the shares of a mutual fund. Every evening, pricing groups at all of the investment management firms toil away to calculate the NAV for their funds in time for them to run in the next day's newspapers. How each fund prices its shares will typically be explained in a "Pricing" section in the prospectus.

The effect the NAV has on price does vary depending on the type of fund you're researching. ETFs and closed-end funds (funds with a set amount of shares that have to IPO before they can trade) trade on the stock market, so their prices are actually market prices subject to discounts and premiums, while traditional mutual funds ( open-end funds, which have no share-issue restrictions and are more common) are priced according to NAV. Regardless of the type of fund, though, the NAV has a profound impact on a fund's share price.

O: Objectives

The fund's objectives are usually the first thing you'll find in the prospectus. They outline what the fund's goals are for investors. Typical examples of fund objectives include:

  • Growth -- increasing the fund's value through the increased value of its assets
  • Income -- providing value to investors by passing on interest and/or dividend income
  • Both -- providing investors with some combination of growth and income

If your fund's objectives are not in line with your own goals as an investor, it might not be the right fund for you.

P: Performance

Even if the fund looks good in every other respect -- good expense ratios, well known fund manager, great objectives -- without performance you're not making any money. Early on in the prospectus, you'll find historical information on the fund's performance, as well as some tools (like definitions and real-world examples) that can help you interpret the fund's financial data.

But while the prospectus is a great reference for a lot of information, there are realistically much better sources of performance-specific information for your mutual fund or ETF. You can head over to your favorite financial Web site instead for more timely and more comprehensive performance measurements than the prospectus can provide (see Ratings).

Q: Quarterly Reports

Many mutual funds are required to provide investors with quarterly reports ( SEC form N-Q). These reports provide a lot of information that could be very useful to an existing investor or potential investor. These reports go into detail about the fund's holdings as well as its financial metrics. If you're interested in taking a look, head over to the SEC's EDGAR site, or if you feel more comfortable at financial Web sites like Yahoo! Finance or Google Finance, they usually offer up this data as well in their own formats.

R: Risk

"Each Fund's NAV will react to securities market movements. You could lose money over short periods due to fluctuation in a Fund's NAV in response to market movements, and over longer periods during market downturns."
-- iShares NYSE Series Prospectus

Yes, you could lose your money in the market due to fluctuations or market downturns. If you've read this far, you've probably garnered at least one thing: Risk is inherent to investing. If you haven't realized that yet, the prospectus will be glad to enlighten you.

Like the risk sections found in the annual reports of public companies, the ones in prospectuses aren't particularly specific or shocking (like the above quote). This section may be worth skimming, but that's about it.

Your appetite for risk (see risk tolerance) should be determined before you decide to invest in a mutual fund or ETF. A couple of ways to gauge whether a fund is aggressive (more risk) or conservative (less risk) include looking at its asset allocation and measures of volatility (see V: Volatility).

S: Selling Your Shares

When you're ready to sell your shares of a fund, as with buying, there may be some rules involved. When you read a mutual fund prospectus, you'll want to take a look at the section that covers redemptions -- or exchanges of your shares in the fund for Net Asset Value (NAV). This will outline any rules and fees (like holding requirements and date restrictions) that are related to redeeming your shares.

With ETFs, this is a simpler process since you can buy or sell shares the same way you trade a stock.

T: Turnover

Turnover is a measure of how frequently a fund's assets are bought and sold. Expressed as a ratio, turnover is calculated by taking the number of shares traded in a year, and dividing it by the total number of shares held by the fund.

For example, if you own a fund that owns 100 shares, and you traded 35 shares during the year, your turnover ratio would be 35% (35 divided by 100 equals .35 multiplied by 100 equals 35%).

Generally speaking, high turnover (or "churn") is considered bad because it racks up excessive trading fees. By their nature, actively-managed funds tend to have higher turnover than funds that mirror an index. Turnover strategies are usually addressed at the beginning of the prospectus along with the investment strategy.

U: Unnecessary Information

Remember how I said that you could expect your prospectus to contain its fair share of "legalese"? With that comes inevitable unnecessary information like privacy policies, disclaimers and marketing fluff. Yes, the prospectus is a very important document. And yes, you might feel compelled to read it cover to cover. But fight that urge. Stick with the topics outlined in this guide and you'll save yourself a lot of time and sanity.

V: Volatility

Understanding the level of volatility -- the propensity of a mutual fund or ETF's price to fluctuate -- is really important if you want to protect the value of your investments. Again, know the asset allocation of the fund, and take that into consideration when you're thinking about investing in it.

A measure of volatility is the beta coefficient (commonly referred to as beta). Beta uses statistics and regression plots to assign a number value to the volatility of a security based on how it responds to market conditions. Higher beta values mean higher volatility. You can find beta values at most financial Web sites -- just enter the ticker symbol of the fund.

W: "Watch It!"

Even after you've used that prospectus to help make an investment decision, take into account the fact that things change. There's one good way to make sure your fund continues to behave the way you want it to, and that's to watch it, by periodically re-evaluating its filings (like annual reports and N-Qs) and updated prospectuses.

So, how often should you check up on that fund? Well, given that it's managed by professionals and filings are only available every quarter or so, skimming through the data every three or four months is a pretty safe strategy and will keep you financially fluent. But, ultimately, exactly how often you're on "prospectus watch," should depend on your schedule, your understanding of the data and your confidence in your fund's portfolio manager.

X: XD (Ex-Dividend)

Is your fund "trading ex-dividend" (XD)? Since those fund distributions are so important, so are their dates. Because distributions like dividends are so common among mutual funds and now ETFs, it's important to take a look at whether that dividend the fund declared will belong to you or not. Whether or not the fund is XD should have a bearing on the price you're willing to pay for it. To find out what the XD situation is, skip the prospectus and check the financial section of your newspaper or your favorite financial Web site (hint: Look for an "x" near the fund name or symbol).

Y: Yield

A measure of performance, a fund's yield is a great way to look at how it's doing in relation to its peers. For mutual funds, yield is determined by calculating dividend payments as a percentage of your initial investment price.

Z: Z Shares

Z shares are a special type of mutual fund share that are available only to employees of the fund. Employee ownership of a fund is important, because these are the people who know the fund best -- their confidence in the fund is a really good sign for the rest of us.

To really dig into Z shares, check out a fund's Statement of Additional Information, which is an SEC-required filing that supplements a fund's prospectus. The SAI presents a range of information that includes the fund manager's ownership stake in the fund.

There you have it, our A to Z guide to prospectuses (and beyond). With this guide, you should be able to use the information provided by a mutual fund or ETF to more effectively make your next investment decision.

Jonas Elmerraji is the founder and publisher of, an online business magazine for young investors.