Proof you should always read a fund’s prospectus before investing

ETFs, Mutual funds, Personal finance, Value investing

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This week’s Barrons (dated 7/3/2006) featured an article about ETFs in an article entitled “The Odd Couple” (subscription required). Personally, I’ve found ETFs to be a better solution than mutual funds for my investment objectives, but the article pointed out that “ETF assets have more than tripled over the past 4 years to $469B [and] there are more than 212 offerings…expected to grow at an average annual pace of 33%”. Nonetheless, the mutual fund industry is still a much bigger whopper at $9.5 trillion, so I suppose there’s still plenty of room out there for ETFs to grow.

I’d never heard of PowerShares ETFs, which offer a way to invest in extremely specialized industries (such as varieties of clean energy). But I was pretty shocked to read in the article that “Unlike most ETFs, PowerShares fund components are reshuffled quarterly in order to reflect best-in-show stocks within each sector.”

I had to look into this further. I’m not averse to trying out different investment methods (just look at the title of this site), but I couldn’t fathom the point of owning an ETF whose holdings changed every quarter. Not only that, but the problem with funds with high turnover rates is that they tend to go hand-in-hand with higher taxes, since usually whenever an asset is sold, a taxable event occurs.

Out of the PowerShares list in the article, I chose . The article noted that its 12-month return as of May 31, 2006 was an impressive 52.93%. I headed over to the website, read through PBW’s summary, and then its .

It goes without saying that most of PBW’s holdings are in small- and micro-cap companies. The fund also started in March 2005, so it has yet to prove a consistent track record. And I had to chuckle when I read that the index provider was named “WilderShares LLC” (I’m sure it was unintentional), though I’ve always been a bit wary of indices created by an independent company that can’t be easily tracked independently by investors. It seems in those cases, all you can do is trust an investment firm when they claim they’ve outperformance versus an imaginary index.

Still, I was surprised to see that total fund operating expenses were a mere 0.70%. Perhaps passively switching out top holdings each quarter didn’t require much effort on the part of the fund manager. I couldn’t find any information on tax expenses, since the fund was too new.

As I read through the prospectus, I noticed they listed a portfolio turnover rate of 9%. This didn’t sound right for a fund that reshuffles its portfolio every quarter. Then I noticed the double-daggered “see footnote” sign, which stipulated, “Portfolio turnover is not annualized and does not include securities received or delivered from processing creations or redemptions.” So if this wasn’t an annualized number, what was it? And lo and behold, above the table I saw that the 9% was for the period from March 3, 2005 through April 30, 2006. A little less than two months’ time right at the inception of the fund.

Ok, so what’s the big deal? Well, if you look at Fidelity’s or Morningstar’s summary of PBW, you’ll see this 9% quoted with no footnotes as the annual turnover rate! You’d never have known the whole story without reading the fund’s prospectus. Here’s the reshuffling in action:

PBW’s Top 5 Holdings

As of 12/31/2005 (1) As of 3/31/2006 (2) As of 5/31/2006 (3) As of 7/04/2006 (4)
Energy Conversion Devices
Suntech Power Holdings
Subpower Corp
Hydrogenics Corp
Evergreen Solar
Active Power
Impco Technologies
Ultralife Batteries
Mechanical Technology
Distributed Energy Systems
Impco Technologies
Mechanical Technology
Zoltek Companies
MGP Ingredients
UQM Technologies
EMCORE Corp
Distributed Energy Systems
MEMC Electronic Materials
Ormat Technologies
Zoltek Companies

Sources: (1) Amex.com; (2) MSN Money; (3) Morningstar; (4) PowerShares

I realize PBW is a tiny ETF, but Morningstar and Fidelity are main sources of information for most investors, and I imagine many people give the summaries listed on those sites a cursory view before dumping money into a fund.

But just about the only place where you’re sure to get information straight out of the horse’s mouth is through reading the prospectus (and even the is worth a read). Sure, investing’s a lot of work and a pain, but who ever claimed that making (or retaining) money was easy?

I’m not saying that PBW’s 12-month 52% return isn’t impressive (though it’s fallen 25% since its peak in May), but the fund is so new that it’s got a lot to prove. Without more information and consistency, I can’t see myself buying into this fund, even if I do support green and clean energy sources. What’s the point, if I can go and pick out a few of these stocks to invest in myself, and choose at my own will when to sell and buy?

If anyone has any thoughts or experiences with Powershares, as usual, I’d love to hear them!

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2 Feedbacks on "Proof you should always read a fund’s prospectus before investing"

Carnival of the Capitalists - July 10, 2006 - Fat Pitch Financials

[…] Proof you should always read a fund’s prospectus before investing […]



4 things to look at before investing in an ETF | Experiments in Finance

[…] 4. Read the fund’s prospectus You knew this had to show up sooner or later. It’s a pain, but why not get the fund’s information and performance straight from the horse’s mouth? Here, fund managers have to disclose their best and worst performing quarters, their investment strategy, expenses, total asset turnover, etc. I’ve written about the importance of reading a prospectus recently already, so I’ll save my breath here. […]



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