Leaving the driving to mutual funds: check out the prospectus map first

The roaring stock market has brought many new investors to Wall Street to buy stocks directly, and it has also brought billions of dollars to mutual funds -- where investors can let someone else pick the stocks and worry about when to buy or sell. But how can you tell if the stock pickers have any experience and know what they're doing? How can you find out what kind of stocks they buy? Where do you learn if there's more risk to this fund than in one of the 500 or so other stock funds you might buy? And how can you figure out how much of a sales or redemption charge you might have, if any?

You can, as the ads say, read the prospectus.

Even though many mutual fund companies are now writing their prospectuses in English rather than legalese, many potential investors still don't bother to read them before they send in their money.

By law, the funds must give a prospectus to every prospective investor. And many funds even attach the investment application to the prospectus to make sure you get the document. But there is no law that says you have to read it -- although you should.

The need is certainly there: Employees manning the phone lines at mutual fund companies have become used to callers who ask what the interest rate is on a fund that invests in the stock market. The answer, the phone personnel patiently explain, is that there is no interest rate or yield, as such, but the net asset value of a fund, like a stock's share price, can move up and down. Some of the confusion comes from the ads that show funds gaining 20, 30, 40 percent or more in the previous year.

Sometimes the reason for those big gains is also the reason the same fund can have a very bad time of it a year later. Some funds, for instance, are classified as ``nondiversified'' and may hold fewer than a dozen stocks in their portfolio. If even a few of the stocks in such a small group have a good year, it can result in spectacular gains. On the other hand, a bad year by just a few stocks can bring on an equally bad year for the fund.

This is the kind of information you find in the prospectus.

Reading it can also prevent surprises like having to pay to redeem your shares, being limited to a certain number of switches from one fund to another each year, or getting a fully taxable distribution when you were not expecting it.

The first question that many people want answered is: Does this fund fit my needs?

The answer can be found under ``investment objectives and policies.'' The law is not too specific about what has to be put in here, so the amount of information can vary greatly. Some funds merely say they will buy stocks and bonds with an objective of growth, or income, or both. Other funds are much more specific, saying they might look for particular industries, like high technology, utilities, banks, real estate, or large, mainstream ``blue chip'' companies.

Generally, the more information you can get out of this section, the better.

It also helps to have more, rather than less, information in the section on ``risk factors.'' This is the place where you find some concrete information behind the axiom that the greater the reward, the greater the risk.

Again, many of last year's high-flying funds got that way by investing in companies that some people would consider risky, a newly issued stock in a biotechnology company, for instance. Because these companies often have erratic growth patterns -- or periods of no growth -- they can also make your fund more volatile in both ``up'' and ``down'' markets than a middle-of-the road fund. The prospectus should tell you this.

Most funds have imposed some sort of investment restrictions on themselves. There is a section of the prospectus that discusses these restrictions.

A fund may, for instance, limit itself to holding no more than 5 percent of its assets in any one company or other issuer. Or it may not invest in any ``cash equivalents'' like money market instruments, even when stocks are sliding and interest rates are up. Or it may (or may not) purchase stocks on margin or use options, index futures, or some other sophisticated investment technique.

Another section of the prospectus will tell you about the costs of investing. With funds that are completely ``no load,'' there is no charge for getting in, no charge for getting all or part of your money out, and no fees for marketing to new shareholders -- also known as 12(b)1 fees.

Many funds have started to pass along marketing expenses to shareholders via the 12(b)1 route, but you may have to look in several sections before you find this information. It might be under ``marketing expenses,'' or ``fees and charges,'' or ``statement of additional information,'' or elsewhere. Any fees, of course, can affect how much money you actually have in the fund, so these sections should be studied carefully.

Even no-load funds, however, have some expenses, whether to pay their own managers or outside investment advisers. Most common-stock funds have an expense ratio of about 1 percent of assets, and most of that is the management fee.

Many mutual funds, but not all, offer individual retirement accounts. You can find this information in the section on services. This section can also tell you about telephone switching, check writing, wire transfers, automatic dividend reinvestment, and other services.

If you've never invested in a mutual fund or read a prospectus before, perhaps the best way to begin is to request several prospectuses from different fund companies. Compare how they present the same information. Seeing the same thing said in different ways may make things clearer and give you a better idea which fund might be the best place for your money.

If you have a question that would make a good subject for this column, please send it to Moneywise, The Christian Science Monitor, One Norway Street, Boston, Mass. 02115. No personal replies can be given. References to investments are not an endorsement by this newspaper.