I clearly remember the first time I heard the acronym “RTFM.” I was relatively new to computers and was on the help line with a customer service rep for a major computer provider that has since gone defunct (you’ll soon understand why).
The rep asked me to check whether my machine was plugged in (Really?!). Then he asked me, “Did you RTFM?” I said, “Huh?” I had no idea what RTFM was. Then, very slowly, as though he were talking to someone who didn’t speak English, he said, “Did you read the [bleep] manual?” And that’s how I learned that acronym.
That story may help explain my penchant for electronic devices like the iPad that are so intuitive that there is no need for a manual. However, investing is far different than technology. In the case of exchange traded funds, the “manual” is the fund prospectus. Before investing in any fund, I always make sure to go to that fund’s website and RTFP (Read The [Bleep] Prospectus).
Why? The prospectus is the place where you find out critical information about the ETF.
It’s designed to help you make an informed decision about whether or not a fund is right for you. In fact, federal law requires investment companies to provide either a full statutory prospectus or summary prospectus to every investor in a fund for just that purpose.
While at first glance prospectus language may seem dry with legalese and arcane terms, SEC rules require prospectus disclosure to be written in clear, concise and understandable language, to use descriptive headings, and to avoid legal and highly technical terminology.
Here’s a quick look at some of the information included in a prospectus that should be of interest to every investor:
Tax Information: A prospectus is required to have a section about the tax consequences of the investment, which is key reading for learning the differences in how various funds are taxed and how various tax treatments can impact returns. For instance, from the prospectus of an ETF that invests solely in master limited partnerships (MLPs), you’d be able to tell that such a fund is taxed as a regular “C” corporation, a tax treatment that could hurt returns.
Investment Approach: The Securities & Exchange Commission requires that fund prospectuses contain information about a fund’s investment goals and principal investment strategies. By reading the prospectus, you’ll be able to gather whether a fund’s investment objective matches your own and whether you’re comfortable with how the fund plans to attain its stated goal. Examples of investment objectives include capital appreciation, current income and results consistent with a certain index. The investment strategy section, meanwhile, contains information about the types of investments you’ll find in the fund and how the fund expects to achieve its goals.
Potential Risks: The SEC also requires that fund prospectuses contain information about the main risks associated with investing in a fund. Examples of the types of risk that could be mentioned include credit risk and market risk. You also may find other interesting tidbits in this section such as whether the fund can change strategies without a shareholder vote. Overall, from this section, you’ll gain a sense for whether you’re comfortable taking on the level of risk associated with the fund.
Fee Table: Prospectuses must contain a summary of the shareholder fees (paid out of a shareholder’s investment) and per-share expenses of a fund, both in tabular form and in the form of an example showing the fund’s total dollar operating expenses. The fee and expense table must show expenses at the end of one-, three-, five-, and ten-year periods.
Track Record: Prospectuses are also required to include information about the past performance of the fund. In fact, the SEC requires that a fund prospectus present such information using a multitude of formulas so investors can better compare one fund’s performance with another. This data should help give you a sense for the fund’s track record and how it stacks up to other funds you are considering. But remember that, as disclaimers always say, “past performance is not an indication of future performance.”
To be sure, the above is just the tip of the iceberg in terms of the juicy information you can find in a typical prospectus. Hopefully, I piqued your interest enough that you’ll be sure to RTFP from now on before you make an investment decisions. Now tell us: What do you look for when you read a fund’s prospectus?