Investment Crash Course: How to read your prospectus

Welcome to the latest post in my Investment Crash Course Series, please check out my earlier articles in the series:

Investing Crash Course: Week 1 (Dow Jones)

Investing Crash Course: Review of Different Financial Products

Investing Crash Course: Money Market Funds

A word of caution while reading my series – I am learning. Everything I publish will be researched and footnoted but you’re going to need to do your own homework.  The information I provide will be based on my own understanding of investing and may not always be a full and complete picture of the topic. Basically, use your head and make informed choices.  That is all.

You and Your Prospectus

Have you ever opened a mutual fund account, IRA, or some other kind of investment account and gotten that thick booklet printed on glossy paper? You know the one. It usually has a reassuring picture of a couple/family of indeterminate Eurasian descent on the front cover. That reassurance is completely negated the minute you open the effing thing and realize it’s written in size 2 font. Nothing good is ever written in 2 font – it’s that fine print at the contract’s bottom noting all those heinous exceptions you agreed too.

For better or worse, this is your simplified prospectus. These things have to be put out to satisfy certain requirements of the U.S. Securities and Exchange Commission[i], the agency assigned to enforcing the federal securities laws and regulating the trading industry.[ii] Essentially, the goal is to provide the investor with information on investment objectives; strategies; target audience; potential risks; and fees and expenses associated with the fund. But now we’re going to make your prospectus fun! Well, maybe not fun, but at least I can help you understand it.

Let’s look at the CIBC Canadian T-Bill Fund, this provides a summary of the objective, target audience, and risk factors:

Your Prospectus: What’s the Objective?

The objective outlines what the fund is intended to do. In this instance, CIBC says it’s meant to preserve the money you put into the fund and keep it accessible if you need it. They do this by investing primarily in Canadian Treasury Bills.

Your Prospectus: Who’s the Target Audience?

CIBC then states who the fund is best suited too, kind of like their target audience. People who want to diversify their portfolio with “cash equivalents”; those who are more likely to need their money within the year; or people who require quick and easy access to their funds.

Your Prospectus: What About Risk?

Let’s talk about the risk, CIBC describes several events that might impact the fund negatively. Some of these were a little hard to break down into understandable explanations. I’ll have to do a little more readings on some of the more complicated ones but here’s a brief rundown of what they mean:

Class risk: If more than one class of funds is offered (T-Bill Premium Funds and T-Bill Regular Funds), it’s possible that one class fund won’t be able to pay from its own share. If that’s the case, funds from the other class will be used. This could impact returns.[iii]

Commodity risk: Some mutual funds invest in commodities (like gold or silver). If these prices go down due to ups and downs in the market, for example, than this may affect the returns.

Concentration risk: Mutual funds are not normally allowed to invest more than 10% in one holding. If the fund is invested in fewer “securities” or “issues”, it’s possible that the fund will vulnerable to market ups and downs and be less liquid (harder to buy/sell).[iv]

Currency risk: Often, mutual funds will trade in securities (T bills, discount papers, etc.) that are bought and sold in other currencies (Japanese Yen, for example). Any changes in the foreign currency exchange rates can impact the fund and negatively affect interest rates.[v]

Derivatives risk: A derivative is a “financial instrument whose value is derived from the value an underlying variable”.[vi] Usually, the variable is a security or an asset like a basket of funds to be sold from one person to another. This one will be explored in fuller detail in a later post.

Fixed income risk: A potential risk with investing in fixed income securities – like Treasury Bills – is that the issuer (government/corporation)  may be unable to pay the interest and principle on maturation. It’s not likely but the risk remains.

General market risk: As it sounds, this acknowledges the possibility that the markets could drop abruptly and unpredictably. Many things can influence the market, like changes in interest rates, economic developments, or catastrophic events.

Securities lending and repurchase and reverse repurchase agreements: These talk about the risks associated with lending on securities (investments) and agreements associated with buying/selling securities (investments). In summary, the lender may default on the loan and the securities invested may fall short of the loan amount and be an insufficient asset. Or perhaps someone will break the agreement and refuse to buy/sell the investments. These circumstances, amongst others, can influence mutual fund returns.

Your Prospectus: What are holdings?

 

Here’s a rundown of some of the holdings you might find in a money market fund, you’ll find the ‘discount note’ mentioned under “Top Holdings” described below:

Treasury Bills (T Bills):  Are short term investment tools put out by Canadian and U.S. governments. They are secure, safe options for investment fully backed by the federal/provincial/state governments issuing them. Usually, the minimum investment amount is $10,000 and can be purchased in maturity terms of 30, 60, 90 days, six months or one year. [vii]

Discount Note: These are similar to Treasury Bills in that they are short term borrowing tools used by Crown corporations/government-backed agencies and corporations with excellent credit ratings. They don’t earn interest, per se, but “mature” after a specified time (one month, two months, etc.) at an agreed upon price. For instance, you buy a Bank of America note at $10.00 and after thirty days, the note is worth $11.25. These are cost-effective financing options for corporations who are looking for inexpensive ways to generate capital for various reasons. Often, investors find discount papers to be good options due to their minimal risk and a secure return.[viii]

Banker’s Acceptance (BA): These are credit investments issued by a corporate borrower and are secured by the financial institution offering them. A BA is a “promised future payment”[ix] – rather like a post-dated cheque – that is backed by the bank and usually arranged over a short term. These may be available at varying minimum investment amounts but tend to be sold in $50,000 or $100,000 allotments.[x] These tend to be attractive to investors because they typically yield a higher return than T-Bills but are a still very low-risk option.

Commercial Papers (CP): These are unsecured promissory notes (formal IOU’s)[xi] dispensed by corporations interested in securing a short term loan at more favourable financing rates that banks offer. Often, corporations use CP’s to finance “seasonal cash flow” requirements or meet other capital needs.[xii] Financial companies often utilize CP’s as a cost-effective option due to their frequent and sizable borrowing requirements.[xiii] Commercial Paper maturity terms can range from one day to one year but are usually issued in one, two, or three month terms. Investors buy papers because they offer the highest returns of the short term investment options. These are highly liquid and can be sold at any time – regardless of maturation term. Companies need to have superior credit ratings to offer CP’s so these are considered as a good choice for the conservative-minded investor.

Crown Corporate Papers: These work very similarly to Commercial Papers but are issued by a crown corporation – like the Canadian Mortgage and Housing Corporation, Federal Business Development Bank, or the Canadian Wheat Board. These are fully backed by the Canadian government and are offered at a high interest rate than T Bills. Crown corporations also yield commercial papers in Canadian and U.S. dollars.

Your Prospectus: What about returns?