Due Diligence of Mutual Funds

Publicly offered mutual funds are required to file a prospectus that provides full, true and plain disclosure.  Most of the time, investors are sent the prospectus by regular mail after purchasing units/shares of a fund.  How many people actually read it?  Most rely on their advisor to summarize the main points of the fund.  It is always possible to get a copy of the prospectus prior to investing.

We understand that most investors do not have the time or interest to read through a lengthy prospectus.  After all, the reason they have hired an advisor is to do that homework for them.  Whether or not you read the prospectus yourself, or rely on your advisor, we recommend that you are comfortable answering the following questions: 1) What are the investment objectives? 2) What is the investment strategy? 3) What are the investment restrictions? 4) Who is the manager? and 5) What are the fees and expenses?

Investment Objectives:  A mutual fund’s investment objectives provide investors with information regarding the funds goals and how it intends to achieve them.  Typical types of objectives are growth (primarily stocks), income (primarily bonds and more recently income trusts) and balanced (combination of stocks and bonds).  The investment objectives may also provide information on the types of investments the fund is allowed or prohibited from holding.  Within these objectives an investor should be able to obtain a feel for the risk/reward nature of the investment.  Most importantly, investors should ensure that the fund being purchased is suitable for their overall portfolio.

Investment Strategy:  The investment strategy or style is important because different management styles tend to perform better in certain markets.  Typical types of styles are value, growth, sector rotation, blend, top-down, bottom-up and combination.  A planned approach may consider a blend of management styles as a component to overall portfolio structure.

Investment Restrictions:  Certain mutual funds provide restrictions on the types of investments.  As an example, Socially Responsible/Ethical Funds may restrict the purchase of certain companies.  Another example of an investment restriction may deal with the minimum investment grade of bonds in an Income Fund.  Many mutual funds may also have clauses such as no one position will exceed 10 per cent weighting within the portfolio.  When purchasing a mutual fund it is also useful to know if there is a mandatory holding period.

The Manager:  One of the most important components to selecting a mutual fund is the portfolio management team.  Most managers provide information to investors regarding their management style and philosophy.  When a member of the management team changes, it is important to assess the experience, style and investment philosophy of the new manager.  A change in management warrants careful consideration and may result in a decision to sell the fund.

Fees and Expenses:  Most prospectuses have a section that is titled “Fees and Expenses” that outlines the initial fees and expenses to set up the fund.  This section will also list the annual fees that are paid to the manager and the ongoing expenses of the fund.  The last part of this section normally outlines the service fees that are paid to the investment firm that has custody of the investment, a portion of which is generally paid to the advisor that works for that firm.  The annual fees and the service fees are commonly referred to as the Management Expense Ratio (MER).

In our next column we will highlight the newest development in the mutual fund industry – F Class Funds.