YOUR mind is already made up. Wall Street Wizards Fund - tops in its class for three years running - is your ticket to ride the stock market. Your neighbors love it. Even Frank Tightwad invested $2,000.
``Skip the prospectus,'' counsels your buddy Frank. ``Nothing but legalese. You've got to move now before the rally ends. They're professionals, they know what they're doing.''
Six months later, ol' Frank is furious.
The problems started when Wizards lost a lawsuit. One of the fund principals was caught waving a wand over the penny stock market and ``magically'' manipulating prices. Sensing the three-year ride might be over, Frank tried to get his money out of Wizards.
But he failed to guarantee his signature when he sent in the redemption request. The fund is under no obligation to tell Frank he messed up. Only months and several phone calls later, he discovers his error. ``You should have read the prospectus,'' a sassy young clerk advises him.
Upon digging out the Wizards prospectus, he finds there's also a 5 percent ``back end'' redemption fee. It'll cost Frank $100 to get his money back.
Frank's case is fictional, but not farfetched. Frank, like many people, has an aversion to prospectus reading. But a prospectus is akin to an operating manual on a new gizmo. By reading it you can avoid costly trial and error mistakes. By ignoring it, you unnecessarily increase your risk.
For instance, the Wizards prospectus warned of the pending lawsuit in the ``litigation'' section. With a little effort, Frank could have found out that risky penny stocks made up a big chunk of the Wizards portfolio. The redemption procedure was spelled out, too.
Most funds require a signature guarantee (authentication obtained from an officer of a bank or brokerage firm, not a notary public) to withdraw funds. Some waive the guarantee for sums under $5,000.
Perhaps Frank can be forgiven for missing a few things, since most mutual funds send inquiring customers only a ``short form'' prospectus. A couple of years ago the Securities and Exchange Commission allowed funds to produce this layman's prospectus ``with a lot of the garbage taken out so it's not so awful to read anymore,'' notes Matthew Fink of the Investment Company Institute, the mutual fund trade group.
There's a financial information chart on the first few pages of every short form prospectus. The chart provides such useful tidbits as investment income, and management and operating fees. It also gives a ratio of expenses to net assets. In most cases, these expenses aren't relevant to choosing a fund.
``It's meaningless unless you're comparing two fixed-income funds,'' says Burton Barry, San Francisco-based editor of No-Load Fund*X, a mutual fund performance report.
``Let's say, Fund A and Fund B both yield about 10 percent. If Fund A has an expense ratio of 1.5 percent and Fund B a ration of 0.5 percent, then it's pretty tough for Fund A to compete on a yield basis when he's giving up 1 percent in expenses.''
But the short form prospectus has, well, shortcomings. Mr. Barry calls it a ``terrible disappointment.'' He notes that it lacks a listing of the stocks contained in the fund and only partially divulges the costs to investors.
The rest of the pertinent data must be obtained from the ``Statement of Additional Information,'' which is available only upon request. Berry advises investors to ask the salesperson for this when they get a prospectus. ``You have to read them both to get all the information necessary for a thorough inspection of a mutual fund,'' Berry counsels.
While performance is the primary factor in choosing a fund, the fees can be a swing vote. For instance, two funds may have comparable performance records. But one charges no initial sales or redemption fee (a no-load fund), while another will take an 8 percent bite out of your original investment. If you plan to be in the fund for four years, that's only a 2 percent annualized charge. But for a one-year investment, 8 percent may be too large a handicap.
Most 12b-1 fees (generally called ``distribution fees'') weigh in at less than 0.5 percent a year. But some go as high as 2 percent and that may be more than some people are willing to pay year after year, especially if a fund isn't outperforming the market.
In the last year or two, the mutual fund industry has had problems with advertising yields on fixed-income funds. There is no industry-wide standard for yield calculations. ``The result has been distortion and exaggeration, if not outright fraud,'' says Berry.
One income fund may offer an average annualized return of 8 percent while a competitor with a similar fund may fudge the numbers to come up with an 8.5 percent yield. And last year, bond prices rose steadily. So income funds took unusually large capital gains, which helped some funds pump up their yield and total return figures.
This year, bond prices have plummeted. That dramatically alters the performance picture. For example, Barry notes that the no-load Ginnie Mae funds he tracks offer an 8.5-9.5 percent annualized yield (dividend paid as a percentage of price as of May 31, 1987).
But with the fall in bond prices, these funds have posted a capital loss. Over the first five months of 1987, the total return (yield plus capital gain) amounts to a loss of 3.5 to 4.5 percent. The total return for the 12 months ending May 31 fell to 5.5 to 6.5 percent.
``I wonder how many Ginnie Mae funds are going to be advertising total return?'' quips Barry. ``If interest rates continue to rise, you'll only see yields advertised.''
Trying to separate his fund from the yield-only advertisers, Peter Thayer of Gateway Investment Advisors, Milford, Ohio, advocates comparing funds on a total return basis. He argues that all fund expenses should be included in the calculation. ``Business Week, Forbes, Barron's all do mutual fund performance surveys but they don't give returns after all the expenses,'' Mr. Thayer says. Following his own advice, Gateway Option Income fund has a chart in its prospectus showing total returns (including expenses) over five years.
The SEC is now reviewing proposals for a standard yield formula and a total return calculation. The commission is expected to vote on the standards this fall. Once settled, this information will go into the prospectus and be a basis for future advertisements. The new standard could be a valuable means for comparing fund performance claims - and another reason to read the prospectus.