Analysis of the Prospectus can assist in the Choice of Fund
The best place to learn more about a particular fund is from its
prospectus. The SEC requires that investors receive a prospectus
before investing or soon afterward. A prospectus is a formal written
document listing relevant information about the fund, the goals of
the fund, the strategies for achieving the goals, securities held by
the fund, risk, historical returns, fees charged, and financial data.
A prospectus contains the following information:
* Strategies for achieving the objectives
* Overall risk
What Is a Hedge Fund?
A hedge fund is not a mutual fund. Hedge funds with fewer than 99 investors are not
required to register with the SEC. Hedge funds cater to wealthy investors who have
a significant net worth ($1.5 million) and are willing to invest $1 million or more.
With the negative stock market returns in 2001 and 2002, hedge funds attracted
large amounts of new capital and a broader-based clientele. Although returns for
hedge funds were low (1 to 2 percent) or flat for 2001, they were nevertheless
much better than the double-digit losses posted by most mutual funds for the same
period. The reason is that hedge funds can take both long and short positions in
stocks, whereas mutual fund managers can only take long positions. In addition,
hedge fund managers can use borrowed money, which can increases their returns.
These positive returns resulted in the introduction of mini-hedge funds in 2002,
a new investment product offered by Wall Street. This type of fund requires a relatively
low investment of $250,000, even though investors still must have significant
assets to withstand any potential risk of loss (Clements, 2002, p. C1). However, the
combination of long and short positions of hedge funds did not perform as well as
mutual funds in a rising stock market.
A hedge fund is a specialized open-end fund that allows its manager to take a
variety of investment positions in the market to seek higher-than-average potential
gains with exposure to greater-than-average risk. U.S. hedge funds, which have
been in existence for almost 50 years, typically take the form of limited partnerships.
Hedge funds have numerous investment styles, such as market-neutral
strategies, in addition to the high- and low-risk strategies. Hedge funds, because
they are not as heavily regulated as mutual funds, do not have the same limits on
the types of investments they can make and have less stringent disclosure
requirements. Investors are limited in how they can withdraw funds. Many hedge
funds allow investors to withdraw money only at the end of the year. Others may
allow investors to withdraw money at the end the year or at the end of each
quarter (Scholl and Bary, 1998, p. 19).
Before investing in a hedge fund
* Read the offering documents.
* Evaluate the hedge fund’s risk and use of leverage.
* Understand how long your money is tied up before you can redeem your funds.
* Ask whether there are any side-letter agreements that offer some investors lower
fees and other benefits (Maxey, 2006, p. B4).
A fund’s objectives can be broadly phrased; the most common are
1. To seek long-term capital appreciation through growth of
the fund’s value over a period of time
2. To seek current income through investments that generate
dividends and to preserve investors’ principal
A fund’s strategy reveals the steps its fund manager might take in
achieving the fund’s objectives. For example, the manager of a
stock fund might buy growth stocks or value stocks of companies
with a particular size capitalization (small-cap, mid-cap, or largecap
A fund’s objectives describe the types of securities in which the
fund invests in addition to the risk factors associated with the
securities. For example, if a prospectus states that its fund invests
in growth securities, you should not be surprised to find that most
of the stocks will have high P/E ratios and can include riskier
small-cap stocks. Consequently, a decline in growth stock prices
would cause investors in this fund to lose money. A fund’s investment
policies outline the latitude the fund manager has to invest in
other types of securities, including options to hedge bets (on the
direction of interest rates or the market) and derivative securities to
boost the yield of the fund. Many conservative funds, which supposedly
only hold blue-chip stocks, have resorted occasionally to
investing in small-company and offshore stocks to boost returns.
The greater the latitude fund managers have in investing in these
other types of securities, the greater is the risk. The types of securities
in which the fund invests outline the overall risk of the fund.
Another measure of risk is how diversified the fund is. If the
fund cannot invest more than 5 percent of its assets in the securities
of one company, it is a diversified fund. However, if a fund has no
limits, the fund manager can choose to invest in a few securities,
which greatly increases the risk of loss if one of these investments
The overall performance of a fund pertains to these concepts:
* Total return
Funds are required by the SEC to provide annualized returns.
These returns can be presented in a table or graphically, showing
results for one year, five years, or ten years. New funds provide
their returns from the date of inception. These returns are presented
on a before-tax basis and an after-tax basis, which shows how
tax efficient the fund is. Funds also must compare their returns to
an appropriate market index.
Many funds can boast that they have attained the number-one
position in some area of performance at some point during their
existence. Note, however, that good past performance may not be
indicative of good future performance. Some funds that did well in
the past no longer even exist.
Several business magazines track the overall performance
records of many mutual funds during up and down markets. These
performance results are a better yardstick to use than the advertising
messages of the mutual funds themselves. From these publications,
you can see how well funds have performed in up markets
and how the funds protected their capital during periods of
declining prices. New funds do not have track records, which
means that their performance during a period of declining prices
may not be available. This statement is especially true for funds
that come into existence during a bull market.
Organizations such as Morningstar (www.morningstar.com)
rate a mutual fund’s performance relative to other funds with the
same investment objectives. However, this rating can be misleading
when you are trying to choose a fund. First, the funds may not be
comparable, even though they have similar objectives. For example,
one fund might have riskier assets than another. Second, past performance
may not be a reliable indicator of future performance.
In choosing a fund, you should look at what the fund invests
in (as well as can be determined) and then try to determine the
volatility in terms of up and down markets.
Yield is a measure of a fund’s dividend distribution over a 30-day
period. It is only one aspect of the fund’s total return, however.
Mutual funds pass on to shareholders any gains or losses, which
can increase or decrease the fund’s total return.
Another factor that affects total return is the fluctuation in NAV.
When the share price increases by 6 percent, it effectively increases
the total return by an additional 6 percent. Similarly, a decline in the
NAV price of a fund decreases the total return. This concept explains
why funds with positive yields can have negative total returns.
Interest on reinvested dividends is another factor that also
might be included in the total return. When dividends paid out by
a fund are reinvested to buy more shares, the yield earned on those
reinvested shares boosts the overall return on the invested capital.
The total return of a mutual fund includes the following three
* Dividends and capital gains or losses
* Changes in net asset value
* Dividends (interest) on reinvested dividends
Expenses are a key factor in differentiating the performances
of different funds. By painstakingly looking for funds with the
highest yields, you are looking at only half the picture. A fund
with a high yield also may be the one that charges higher expenses,
which could put that fund behind some lower-cost funds with
lower yields. Fees reduce total returns earned by funds. You cannot
count on future performance projections unless the fees and
expenses charged by mutual funds are fairly consistent. A mutual
fund prospectus has a separate table with a breakdown of expenses.
This table typically shows the different charges paid for either
directly by shareholders or out of shareholders’ earnings in
the fund: load charges, redemption fees, shareholder accounting
costs, 12(b)–1 fees (explained below), distribution costs, and other
The mutual fund industry has been criticized for its proliferation
of fees and charges. Granted, these are all disclosed by the
mutual funds, but you need to know where to look to find the less
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