By Paul Vargo

To the average retail investor, reading and understanding a prospectus can be a daunting task.  A prospectus is an informational packet created to assist investors in understanding the securities that they wish to invest in.  For example, a mutual fund prospectus will describe the objectives, risks, and other essential information about the fund.  Unfortunately, many average investors see these packets as long and difficult to understand and will often discard or ignore the prospectus completely.  By doing this, the investor may be making a costly mistake and taking a position in a fund that is unsuitable.

When an investor is determining if a mutual fund is right for them, they should consider these five things:

• Investment Strategy
• Fees
• Portfolio Turnover
• Limitations of Redemption

Investment Strategy

The first thing an investor should look at is the investment strategy.  The investment strategy tells the investor who should invest in the fund.  The investment strategy should give the investor a basic understanding of what the fund’s goals are.  The investment strategy will also tell the investor what kind of investments the fund holds and the associated risks.

Fees

The next thing a mutual fund investor should look at are the fees associated with the investment.  There are generally two types of fees associated with mutual funds: the load and the annual expenses.  The load is usually expressed as a percentage and is a one-time fee charged to the investor.  For example, a 5% front-end load on a $1,000 investment would be $50.  Thus, an investor with $1,000 to invest would be investing $950 into the actual fund.  Annual expenses, on the other hand, are paid out of the funds general assets and while the investor may not directly see this expense, it important to understand that it exists.  Essentially, the higher the annual expense, the less money the investor will return on investment.  As an investor, it is important to understand how these fees can eat into your profits.

Portfolio Turnover

Portfolio turnover is a percentage showing how often the assets in a mutual fund are turned over.  Because portfolio’s that turnover at high percentages generate high capital gain taxes, an investor needs to be aware of how this may affect their financial situation.  When investments have higher tax rates, investors are left with less money and diminished profits.  Thus, a tax-savvy investor may want to invest in a passive fund with lower portfolio turnover rates.

Limitations of Redemption

Understanding the limitations of redemption should be one of the most important things to an investor because it shows an investor how quickly they will be able to access their money.  While mutual funds are typically not too difficult to sell, there may be other restrictions placed on the investor.  Thus, it is vital for an investor to know how and when they plan on getting out of an investment before they purchase it.