Prospectus

A prospectus is the document through which an issuer discloses what it is selling to the people it is selling to. In ordinary conversation the word means one specific thing: the booklet a mutual fund or exchange-traded fund provides, describing its objectives, principal strategies and risks, its fees, its past performance, and who manages it.

The statutory definition is much broader, and the gap is worth understanding because it explains a great deal about how securities are marketed. Section 2(a)(10) of the Securities Act of 1933, at 15 U.S.C. 77b(a)(10), defines the term to mean "any prospectus, notice, circular, advertisement, letter, or communication, written or by radio or television, which offers any security for sale or confirms the sale of any security," subject to two carve-outs. So in law a prospectus is not a format at all: it is any written or broadcast communication that offers a security. The familiar booklet is the version that meets the content requirements of section 10 of the same Act, which is why it is properly called a statutory prospectus.

The breadth of the definition is the point of it. By sweeping in notices, circulars, advertisements and letters, section 2(a)(10) makes every communication that offers a security subject to the Act's disclosure and liability rules, rather than only the document an issuer chooses to label a prospectus. The two carve-outs then create the space for ordinary marketing to exist. One covers a communication sent after the registration statement is effective, where it is proved that a full section 10 prospectus was sent to the same person at or before the same time. The other covers a notice or advertisement that states where a full prospectus can be obtained and does no more than identify the security, state its price, and say who will execute orders, together with anything else the SEC permits by rule. The structure is that a short piece of marketing is allowed precisely because the long document stands behind it.

For funds there are two documents, and the short one is not a summary someone wrote. The SEC describes the pair plainly: the statutory prospectus is the traditional long-form document, and the summary prospectus, used by many funds, "is just a few pages long and contains key information about a fund." The important structural fact is that the same key information is required at the beginning of the statutory prospectus, in a standardized order that the SEC sets: (1) investment objectives and goals; (2) the fee table; (3) investments, risks and performance; (4) management, meaning the investment advisers and portfolio managers; (5) purchase and sale of fund shares; (6) tax information; and (7) financial intermediary compensation. Because the sequence is fixed, two funds' documents can be compared item by item without hunting.

The fee section carries a computation the fund does not get to design. Form N-1A requires the fee table to be followed by an Example whose stated purpose is "to help you compare the cost of investing in the Fund with the cost of investing in other mutual funds." The assumptions are prescribed: a $10,000 investment held for the periods shown, redeemed in full at the end, with a 5% return each year and operating expenses unchanged. The result is a set of dollar figures for one, three, five and ten years. What the fees themselves mean, and how they compound, belongs to the expense ratio and the sales load; the point here is that the comparison is standardized by rule rather than assembled by the reader.

What a prospectus is not. It is not a recommendation, and it is not a prediction. It is also not the complete file: a fund's prospectus points to a longer statement of additional information for the material that does not belong in a document meant to be read. Municipal securities are a separate regime again, offered under a disclosure document of their own rather than under a registered prospectus.

An issuer files a registration statement with the SEC; the prospectus is the part of it delivered to investors. For a fund, the document is updated at least annually and delivered when shares are bought, and both versions are free from the fund company's website, by phone or by mail. Reading it efficiently means using the fixed order: objectives first, then the fee table, then strategies, risks and performance, then management, then how to buy and sell, then tax, then what the fund pays intermediaries.

A hypothetical example of the Example. A fund reports total annual fund operating expenses of 0.75%. On a $10,000 investment held for a year with no change in value, that rate is $75. The prospectus figure will be a little higher, because the required assumptions include a 5% return each year, so the percentage is charged against a balance that grows during the period. The same assumptions are then carried out to three, five and ten years, which is where the difference between two funds becomes visible: at ten years the Example is comparing accumulated costs on a balance that has been compounding the whole time, not ten times the first year's number.

Two things about that table are easy to miss. It assumes the fund's expenses stay the same, which they need not. And it reports costs only, so a fund with a higher figure is not thereby the worse investment; the table answers what ownership costs, and nothing else.

Pros

• The content and, for funds, the order are set by rule, so the same information appears in the same place in every document.
• The required cost Example puts two funds on identical assumptions, which no marketing material has to do.
• The summary version makes the key items readable in a few minutes rather than an hour.
• The statutory definition reaches advertisements and letters, so the liability rules follow the offer wherever it goes.

Cons

• Length and legal drafting make the statutory version hard going, and the parts most people need are not the parts that take up the most space.
• The cost Example assumes expenses stay constant and returns are a steady 5%, neither of which is a forecast.
• Past performance shown in the document describes the fund, not the future, and is the section most likely to drive a decision anyway.
• Delivery often happens at or after purchase, so the document arrives after the decision it was meant to inform.