“Always consult the fund’s prospectus before investing.” So goes the generic tag-line accompanying every exchange-traded fund’s (ETF’s) advertisement. It’s become such a customary phrase by now that most investors just glance over it and never once crack open the all-important document. However, they may be doing themselves a huge disservice by not consulting an ETF’s prospectus.
It’s here that investors will find all sorts of information regarding what the fund is all about; information that can make or break their investment.
And while reading a prospectus may seem like a daunting and boring task, it’s something that must be done. Luckily, here at ETFdb.com, we’ve come up with this handy guide to help make reading through the document that much easier. With a little knowledge about reading these things, you’ll become a pro at understanding what’s really going on with your ETF.
Be sure to also read When the Fine Print Matters for ETF Investors.
Prospectus Basics
Thanks to the Investment Company Act of 1940, ETFs, mutual funds and unit investment trusts (UITs) are legally required to provide a prospectus to prospective investors. Investors can obtain these documents directly from ETF sponsoring companies through mail, email or phone. Many fund companies now make their prospectuses available for download on their websites. Additionally, financial planners and advisors are legally required to provide you with a prospectus before you sign on the dotted line. The document is filed with the Securities Exchange Commission (SEC) and contains pages upon pages-usually 10 to 20-of information detailing every nuance of the fund.
And given that it is a legally binding document, a prospectus tends to be less than reader-friendly.
However, the legally binding nature of the document and standards set forth by the SEC actually provide a framework for easy understanding. All modern prospectuses contain the same information sections-pretty much in the same order-for every ETF or other fund in the United States. That makes it easy to pick out what’s important and what’s just legalese. It then comes down to deciphering this information and whether or not the ETF is worthy of your hard-earned dollars.
The Important Sections of a Prospectus
Every ETF prospectus contains nine essential sub-sections. These sections are headlined and make it easy to understand what’s contained in them. They are Date of Issue, Minimum investments, Investment Objectives, Investment Strategies, Risk Factors, Performance Data, Fees & Expenses, Tax Information, and Investor Services.
Some of these are less “important” than others. For example, the date of issue is when the prospectus was filed. Most funds will file a prospectus semi-annually, so make sure you read the most current document. Likewise, the investor services section details contact information, issues and redemptions authorized, participants information, board information, etc. For ETFs, the minimum investment section is always one share and is included in the investor services part. For the most part, this information can be glanced over pretty quickly by the average retail investor. The nitty-gritty of the remaining prospectus is what really counts.
Investment Objective: The underlying goal of the ETF must be clearly stated. In the case of index ETFs, it will usually state which index the fund is trying to replicate. For active funds, there’s usually more leeway. Will the active ETF aggressively try to grow capital? Boost current income? The fund’s objective-whether passive indexing or active management-should match your own objective. Additionally, the ETF can’t change this objective without a vote from its board of directors.
Investment Strategies: How exactly is the ETF going to meet those objectives? That’ll be found in this section. The prospectus will actually spell out what the ETF will be holding-from stocks to futures contracts. This will also include the range of percentages that it will hold in each category. If the fund is an index ETF, it will also break down the construction of the underlying index, how it defines the universe of securities within its index, and how it picks them. Remember, there are multiple strategies to reach the same investment objective.
Risk Factors: This section will contain what exactly could go wrong and derail the ETF’s performance. This is usually the biggest section of the prospectus. For example, if the fund invests in international stocks, items such as currency risk, political risks, and economic risks will be included. Each of the potential risk factors for the ETF will have smaller sub-headings spelling out what exactly the risk entails. And believe me, the lawyers at each ETF group really do want you to understand what could hurt the fund’s performance. Almost every contingency for failure is spelled out here. Skipping this piece of the prospectus could prove detrimental to an investment.
Performance Data: Included in the prospectus is detailed information about the ETF’s past performance. You’ll find the ETF’s best and worst performing quarters, as well as charts illustrating the fund’s performance over short and long periods of time. Also listed here will be information on how the ETF performed versus its chosen benchmark. In the case of index ETFs, that will be the underlying tracking index of the fund. The performance data listed is based on a standard formula created by the SEC and is designed to help investors compare one fund to another. Just remember, past performance is no guarantee of future results.
Fees & Expenses: This section describes the costs associated with buying and holding shares of the ETF. Brokerage commissions on their purchases and sales of an ETF are not included in this number. Fees are expressed as a percentage of the value of your investment-such as 0.60%-and are paid yearly. A prospectus will break down what the fees are going to: management expenses, acquired fund fees, etc.
In this section, the prospectus will provide a hypothetical example over 1-, 3-, 5-, and 10-year periods of what the cost of ownership will be. The basis is typically a $10,000 investment and assumes a standard metric of performance. In all honesty, this example is pretty meaningless as fund expenses change all the time as does average returns and portfolio size.
Also included in the Fees & Expenses section is information about the ETF’s turnover. Portfolio turnover can be seen as a silent fee as the more times a fund buys or sells securities the more the transaction costs are passed on to investors.
Tax Information: This section will include information on the tax status and implications of the ETF’s distributions, and whether they will be treated as dividend income, returns of capital or capital gains (long or short). Keep in mind, this can change year to year. Additionally, if the ETF is futures based, information on the fund’s K-1 statement will be listed here.
The Bottom Line
A ETF’s prospectus is a pretty daunting document. And at first blush, it’s quite hard to read and understand. However, by understanding a simple framework, the nine important sections of a prospectus make understanding the document quite easy. By following the easy-to-read outline of a standard prospectus, you should be able to quickly compare and contrast which ETFs are worth your money.
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Disclosure: No positions at time of writing.
