The first thing I look in any prospectus is the cost. How much will this fund cost me when I purchases and how much per year will the fund management company charge. In this example I will use the BlackRock Global Allocation Fund which one of the largest mutual funds by assets under management (BlackRock Global Allocation Fund Prospectus). These fees can be usually found near the beginning of the prospectus. Sometimes they can be buried deep in the prospectus because the fund is mixed in with other funds. Depending on the account type, in this example lets use retail taxable account will dictate the costs an retail investor will be charged.
Typically a retail investor in a taxable account usually purchases class A or A shares version of the mutual fund. If an retail investor were to buy BlackRock Global Allocation Fund Investor A Shares the investor will be a charge a load (maximum sales charge) of 5.25% of the total dollar purchase amount. Let's assume the retail investor wishes to invest $10,000. The retail investor will be charge $525 just to invest in the BlackRock Global Allocation Fund Investor A Shares so the net proceed that are invested into the fund is $9475. The $525 goes to your broker or financial advsior as compensation from the fund company. Pretty sweet deal dont you think? Your broker is given the incentive to push mutual funds that pay him or her a percentage of the assets they bring to the fund company or companies. I will discuss that subject in another blog entry.
The next step, is I look for the annual expenses of the fund which can usually be found on the same page as the load or maximum sales charge. The annual expenses is usually labeled Total Annual Fund Operating Expenses, sometimes this fee has other names as Net Expense Ratio. In BlackRock Global Allocation Fund Investor A Shares, the annual operating expenses is 1.16%. This means on an annual basis you are being a charge a rate of 1.16% on your total dollar investment in the fund. Let's assume you had a 0% gain in this fund and you held the fund for a year. Remember you net your proceed of $9475 that was invested in the fund? Well on an annual basis you will be charge 1.16% of $9,475 or $109.91 (I will use $110 for simplicity purposes). In the one year you owned this fund you have been charge $635 or 6.35% just for owning this fund. Pretty expensive you say, oh yes one more thing, you don't get a bill, this gets taken out of your account. Let's stick with the first example of cost and assume you had a 10% gain in the fund. Now your investment in the fund is worth $10,423. Guess how much you will be charge in dollar terms to own this fund? You be charge 1.16% of $10,423 or $121 per year. The more asset you have or the more your investment grows to more you get charged. Sweet deal for the mutual fund company. The fund company has a vested interested in growing assets which doesn't necessarily means growing your investment. This issue too is for another blog entry. In year 1 using the 2nd example you paid a total of $646 to both the broker and the fund company or 6.46% of your investment. Granted your net gain is $423(10423 - 9475 - 121-525) or 4.23%. See how fees drag down your return. If the broker was out of the mix your gain would have been $11,000 - $10.000 - 127.6 (1.16% of $11,000) = $872.40 or 8.72%. To be fair the load is only a one time fee charged at purchase but still why pay when other cheaper alternatives exist.
I usually dig into the how the annual operation expenses are calculated by looking for the management fee and the 12b-1 fee or distribution fee. It can get more complicated by the reading the footnotes but I want to keep this simple. For the BlackRock Global Allocation Fund the management fee is 0.75% across all shares classes. Each year assuming this fee doesn't change the management team receives 0.75% of the market value of your investment. Next I look for is the 12b-1 fee or distribution fee (12b-1 or Distribution Fee). This fee is charged to cover marketing expenses or distribution of this fund. For example, you may own mutual funds at various online brokerages or full service brokerages. This fee is charge to cover the distribution fund marketing materials such a prospectus, annual reports, semi annual reports and other related report. The fund company covers these expenses to the brokerage firms but guess who really pays this fee? You guessed it you do. Typically the 12b-1 is 0.25% and it calculated in the annual expenses.
The next step is I look for the portfolio turnover. The reason I look for the annual portfolio turnover is to determined if the management fee justified. The portfolio annual turnover ratio for BlackRock Global Allocation is 39%. This means the fund changes the 39% of the fund's investments. Lets assume there are 100 stocks in a fund, with a portfolio turnover rate of 39%, 39 of the stocks have been replaced, bought or sold. For BlackRock Global Allocation Fund with a 39% annual turnover rate, the management fee of 0.75% seems pretty reasonable.
Next step in the process I read the principal investment strategy and the investment objective. The investment objective is usually the first thing you see on the prospectus so I may do a quick glance before I go into my process. In these two sections you will read what are the fund's goals, how the fund intends to invest, what type of investments the fund will make, assets the fund will own and how the fund will be benchmarked. I read this section because it is important to know if this fund is suitable to my needs. I will not get into detail of what BlackRock Global Allocation fund is investing but the fund is a multi asset fund that invests in stocks, bonds, REITs and other assets and derivative instruments.
Finally I look for the biographies of the portfolio management team. In this section I am looking for each individuals tenure managing the fund. I typically like to see an individual running the day to day operations of the fund 3-5 years or greater. Sometimes the portfolio manager started as an analyst for the fund so my criteria for tenure is less strict. In BlackRock Global Allocation Fund, Dennis Stattman has been managing this fund since 1989, so the performance and risk figures can be tied to him for analysis.
In addtion, I want to mention that I also look at the fund supplements if any usually found at the very first page. The supplements are very important because it tells you of any changes that has occured after the prospectus has been issued. What I look for in this section are portfolio manager changes, invesmtent objective changes and benchmark changes.
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