What to Look for in Annual Reports
One of the things you pay a mutual fund for is its annual report.
Postage and production costs are a small piece of a fund’s expenses, but they are a cost of doing business that comes out of your pocket. So if you don’t read the reports and proxy statements that your fund, by law, must send out, you are both wasting your money and missing out on a resource.
Fund companies are producing more readable, plain-English documents these days. Not only is the Securities and Exchange Commission demanding this, but funds now are graded on the quality of their paperwork by firms like Morningstar and Value Line; it makes no sense to invest with firms whose reports are written in jargon and gibberish.
That said, as we enter the throes of annual report/proxy season, here is a guide on what to glean from the semiannual barrage of paperwork hitting your mailbox:
* Performance: Funds must compare returns to at least one benchmark, either the particular market index they try to beat or the average performance of peer funds. Good annual reports show both.
Find out why the fund has beaten or lagged those benchmarks. Maybe the fund shoots for reduced risk and average performance. Maybe there is a management problem.
* Statements From Management: You want a candid, clear explanation of what happened to the fund, what to expect and why.
Bill Benintende, who oversees production of shareholder reports for the John Hancock Funds, says, “If you are paying for these people to manage your money, it is extremely important that you read what they plan to do with it and how they see their strategy.”
Management should answer questions that any normal, curious shareholder would have, such as why a fund’s performance was lackluster. If all you get is “Don’t worry, be happy,” get nervous and angry.
* The Fund Portfolio: Although it is out of date by the time you read a semiannual report, the listing of the portfolio nevertheless holds clues to strategy and performance.
Look for a portfolio that is consistent with your expectations in terms of diversification, international exposure and size of companies. A small-company fund, for example, should not have a lot of big-name stocks in it. A portfolio concentrated in a few stocks or in one or two industries will be more volatile than a diversified one.
After you review your fund, examine the holdings of your funds collectively to see whether your portfolio suffers from overlap--which increases volatility--or has gaps, such as no small company exposure.
* Changes in Structure: The proxy is where you find out what your fund wants to do next; all dramatic changes in style and strategy must meet with your approval.
Expect all proxy proposals to pass, so be sure the fund still fits your investment objective. Managers may just want leeway for the future; still, you should be alarmed if they want the option to do something out of character, such as add risky securities to a safe fixed-income portfolio.
In addition, scan the annual report to make sure the fund has not changed managers (many don’t notify investors until the next report). If there has been a change, call for performance details from the new manager’s previous funds; your fund may pick up new characteristics.
* Expenses and Portfolio Turnover: These numbers in the “financial highlights” can be telling. A fund with a high or rising expense ratio is not maximizing your returns. High turnover can lead to big capital gains tax liabilities, which you end up paying.
* Asset Growth: If a fund hasn’t grown at all, it is losing money, investors or both. That is not a trend you want to see repeated.
* The Auditor’s Report: Just count the paragraphs; if there are more than three, there could be trouble. (Large fund groups may dedicate one paragraph to naming all of their funds; they are allowed four-paragraph reports.) Avoid any fund with auditing problems.
If you are determined to read auditors reports, look for these words in the last paragraph: “financial statements . . . present fairly . . . the financial position . . . in conformity with generally accepted accounting principles.”
Charles A. Jaffe is mutual funds columnist at Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, Box 2378, Boston, MA 02107-2378.
