July 2009

I’ve written before about the importance of reading a mutual fund prospectus. Just the other day as I was researching my article on low-cost, socially responsible investment options, I experienced a perfect example of why it’s so important.

According to the fund list I found, Pax World Investments’ Pax World International Fund was the lowest cost “socially responsible” international equity fund, with an expense ratio of 1.40%. But before suggesting it on the blog, I thought it would be wise to download and read the prospectus. (pdf here.)

If you flip to page 40 (Fees & Expenses), you’ll see the real costs of running the fund. The total? 11.82% of assets! (Seriously. Go look.)

So how was it that a 1.40% expense ratio was listed elsewhere? As happens frequently in the mutual fund industry, the management company waived a portion of the expenses (in this case, almost 90% of the expenses).

The catch is that this waiver of fees isn’t permanent. In this case, it’s through 12/31/2012, but in many cases, the management company can discontinue it at any time.

Loss Leaders

Some fund companies run certain funds at a loss on an ongoing basis. For example, Schwab’s S&P 500 Index Fund only charges shareholders an expense ratio of 0.09% per year, when its gross expense ratio is 0.21%.

My understanding is that their purpose for this fund is much the same as that of milk at the grocery store: sell it at a small loss in order to bring in customers, to whom they can sell more profitable products (like higher cost, actively managed funds).

The existence of a fee waiver wouldn’t bother me much if I were pondering investing in one of Schwab’s index funds. In those cases, even if the waiver disappeared, it wouldn’t be that big of a deal as long as you noticed it within a couple years and switched to a lower cost fund. (Note: This would mean continuing to read prospectuses from time to time, even after investing in the funds.)

But that’s one big waiver!

But in the case of the Pax World International Fund, we’re not talking about a 0.12% jump in expenses if/when the waiver disappears. We’re talking about an increase in expenses equal to more than 10% of fund assets. I don’t know about you, but that would make me extremely hesitant to invest in the fund.

The Lesson: Read the prospectus

Assuming you plan to own a fund for several years, you need to know not only what its expenses are now, but what they’re likely to change to in the future. That’s the kind of information that you’ll only find in a prospectus.

July 30, 2009 11 comments

The most basic skill in picking stocks is the ability to read financial statements. From an income statement, balance sheet, and cash flow statement, a skilled reader can supposedly glean all sorts of valuable/actionable information.

As someone whose career and educational background is in accounting, I’ve spent my share of time creating and reading financial statements. What many non-accountants seem to miss is that most of the information included in them is extremely imprecise.

The reason behind this lack of precision is that, as I once heard the Controller of a Fortune 500 company say, “accounting figures are estimates, based upon estimates, based upon questionable assumptions.” (Depreciation and amortization expense are two prime examples.)

To give you an idea of where financial statements stand, I prepared this handy Guide to Accuracy & Precision:

The general rule of thumb is that line items on financial statements cannot be trusted beyond their first significant digit. (And I’ve seen more cases than I care to count in which I’d argue that even that was a stretch.)

Now, does all this mean that financial statements are completely worthless? No, not completely. But before you go betting your life savings on a stock, at least be aware of the quality of information you’re dealing with.

July 28, 2009 6 comments