A prospectus is a document that either describes an offer to sell securities to potential investors or describes the history, goals, and financial performance of a mutual fund. When a company conducts an INITIAL PUBLIC OFFERING
(IPO), it must provide a detailed statement of the proposed use of funds, and facts about the company soliciting funds, as per SECURITIES AND EXCHANGE COMMISSION
(SEC) guidelines. Sometimes referred to as a “red herring” among financial analysts, an IPO prospectus also includes information about the backgrounds of company officers, RISKS
associated with the INVESTMENT
, and any legal matters of concern to potential investors. During the peak of the DOTCOMS IPO era (1999–2000), many entrepreneurs with little experience and a BUSINESS PLAN
that included not much more than an idea successfully “floated” IPOs, raising hundreds of millions of dollars. Careful scrutiny of their prospectuses would have shown the high degree of risk associated with these investments. A mutual-fund prospectus is similar to an IPO prospectus, listing the fund’s holdings, its investment objectives, and strategies the fund manager uses or may use to achieve its objectives. Until 1998, mutual-fund prospectuses were highly complex, legal documents designed mostly to protect the fund management from lawsuits. One study found that almost 50 percent of investors did not read the prospectuses of funds they invested in. In 1998 the SEC began requiring mutual-fund managers to create “userfriendly” prospectuses, replacing legal jargon with English and providing a standardized summary including the fund’s investment objectives, strategies, risk, performance, and fees.
Investment advisors recommend investors scrutinize mutual-fund prospectuses, focusing on
• whether the fund’s investment objectives are consistent with their own investment objectives
• the free schedule
• the experience of the current fund managers
• the fund’s performance history
• the risk statement
Many investors tend to focus on the mutual fund’s current holdings and recent performance in deciding whether to invest in it. Studies have shown that past performance is often hard to replicate, and investors who “chase earnings” are frequently disappointed. Also, many fund managers engage in what is known as “window dressing”—selling poor-performing stocks or stocks that have received negative publicity and purchasing current “hot” stocks just before the end of a quarter, in order to suggest to investors that they correctly purchased the winning stocks.
See also MUTUAL FUNDS