Required Investor Reading: What to Look for in a Prospectus

“Carefully consider the investment objectives, risks, charges, and expenses before investing. The prospectus contains this and other important information. Read carefully before investing.”

This is the standard boilerplate language you might see when considering an investment—a mutual fund, exchange-traded fund (ETF), stock, or bond, for example. Not coincidentally, the word prospectus is tied to the Latin root for “to view” or “look forward.”

Here’s another Latin lesson: caveat emptor. For investors, the prospectus provides a critical “buyer beware” reminder and guidebook for making sure you know what you’re getting into. It may not be your idea of light reading, but don’t let anyone tell you to dismiss these documents as a bunch of legal jargon to just skim through before you hand over your money.

Prospectuses contain clues that can help investors gain a firmer grasp on a company or fund’s management, strategy, and longer-term prospects, according to Viraj Desai, director of research modeling at TD Ameritrade.

“A careful reading of the prospectus can help investors understand some of the risks of investing to make a more prudent investment decision,” Desai said. Here are a few investor basics on prospectuses.

What Is a Prospectus and Where Can I Find One?

A prospectus is an official company document that describes basic financial and business information. In your investing journey, you’re likely to come across two distinct types. Though each differs in terms of the type of information included, the general purpose is the same—to inform potential investors of risks and other important information. 

• Company prospectus. This is for a company offering securities for sale—such as before an initial public offering (IPO) or bond issuance. For publicly traded U.S. companies, or companies planning to sell shares in an IPO, prospectuses are available on the Securities and Exchange Commission’s (SEC’s) online EDGAR platform. Many company prospectuses are contained in a form S-1, which is a registration statement under the Securities Act of 1933. You can also get a prospectus from a company’s website.

• Fund prospectus. A fund prospectus—for a mutual fund or ETF, for example— provides information about the fund’s costs, investment objectives, risks, and performance. Typically, each fund family has a prospectus available for each individual fund. You can also get one from your broker or other financial professional. TD Ameritrade clients can see the prospectus of any fund it offers. See figure 1 below.

Prospectus Info for Companies Issuing Securities 

In addition to basic financial details, such as revenue, profit, and expenses, a prospectus can include:

• History of the business
• Description of management
• Major shareholders
• Expected price and date of an IPO and how IPO proceeds may be used
• Ticker symbol
• Risks to the business or buyers of an IPO

A prospectus sometimes makes news, especially if it’s from a high-profile, fast-growing startup with a widely anticipated IPO in the pipeline.

Uber Technologies, for example, detailed a number of items that are likely of interest to investors in its 300-page S-1 filing in April 2019. It included 2018 revenue ($11.3 billion), trips taken by the ride-hailing company’s users (1.49 billion in the fourth quarter), and a letter from CEO Dara Khosrowshahi (explaining that Uber is a “once-in-a-generation company, and the opportunity ahead is enormous”).

A company prospectus can also offer clues as to potential red flags. Is the company making or losing money? Sometimes it’s in the eye of the beholder. You might watch for terms like “adjusted EBITDA” and other terminology involving how the company defines its net income or losses.  Also, scour a prospectus for details on a company’s business plan, risks of all varieties (natural disasters, recessions, geopolitics, etc.), and how it may award executives with shares or options.

Mutual Fund Prospectus: Info and Potential Red Flags

According to Desai, a fund prospectus outlines the parameters of a fund’s investment strategy and mechanics of the investment vehicle. A fund prospectus actually comes in two forms: statutory and summary.

The statutory prospectus is the traditional, long-form disclosure. The shorter summary prospectus is often just a few pages long and contains key information about a fund, but fewer specifics, and sometimes less legalese. Both, however, contain important information, including the fund’s investment objectives or goals, strategy, principal risks for investors, fees and expenses, and past performance.

“Mutual funds must provide a copy of the fund’s prospectus to shareholders after they purchase shares, but investors can—and should—request and read the fund’s prospectus before making an investment decision,” the SEC said on its website.

For mutual fund investors, prospectuses outline critical “parameters and guardrails the fund and its management team are committing to operate against,” Desai emphasized.

Careful review of the prospectus can highlight several classes of risks, such as the use of leverage or derivatives, diversification (or its lack), and other areas. “The prospectus will highlight in some cases the qualifications of lead investors so that clients can confirm that assets they delegate will be managed by an experienced team,” according to Desai. 

In a mutual fund prospectus, investors “should keep an eye out for anything that could disrupt the going concern of the fund,” Desai said. “Low tenure of portfolio managers is worth investigating to see if turnover might be an issue or if the team is adequately experienced.” Other red flags could include an overly complicated investment strategy, a longer-than-average list of potential risks to investors, or “excessively complex” fee schedules. 

Bottom Line

Investing in today’s markets can sometimes feel like a double-edged sword. On the one hand, the sheer number of investment alternatives, combined with accessible and easy-to-use platforms, makes investing a few clicks or taps away. But before you invest, you need to do your homework. And yes, that means following the prospectus disclaimer: Read carefully before investing.