Answers to three good investor questions

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Fund investors have questions, lots of them.

Here are three particularly good ones I received recently, the kind that probably speak for a wide range of fund shareholders. Enjoy.

Today I got a prospectus from a fund I like. I can't make heads or tails of it. What are the three or four most important things to look for in there, and don't give me more than that because three or four is all I can take.

- Brenda from Wheaton, Ill.

My four must-reads (Brenda's last caveat is why this isn't a full column, but you honestly didn't think I would stop at three, did you?):

1) Investment strategy. This is more detailed than the "investment objective," and it tells you how management plans to make money. If you own just a few funds, the easy way to diversify is to buy issues that follow different strategies. And if the strategy makes you queasy, you know the fund is not for you.

2) The fee table. Costs have a lot to do with determining performance. Here's what you won't see in the tables: The average domestic stock fund has an expense ratio of about 1.4 percent, with the average bond fund being closer to 1.1 percent. If the prospectus shows "total annual fund operating expenses" above those levels, make sure you look at the table where the firm shows the actual costs in dollars. That may be enough to convince you to keep looking.

3) Return table and chart. Examine a fund's best and worst year, and assume that the fund could repeat its biggest swing, and smack you in the head with it. If that image frightens you, maybe you should avoid the fund.

4) Financial highlights. Go to the back of the booklet for this table, which contains the fund's audited financial performance for each of the past five years. You'll get an idea of how the share price has fluctuated, you'll see its turnover rate and more.

Ideally, if you look at these four things and still like the fund, you'll go further, like into the risk factors and on to its policies for buying in or selling out. But if these four points don't give you a good start, consider hiring a financial adviser, as you will be more comfortable paying for assistance than you are in going it alone.

I saw a list of the worst funds based on different time periods, and names like the Ameritor, Van Wagoner and American Heritage funds are on there for pretty much every time period longer than a year. How can a fund do that poorly for so long and still stay open?

- John from Santa Barbara, Calif.

Funds can stay open until the last one out turns out the lights. For some of these funds, performance has been so bad that investors effectively have given up (or they have moved on and forgotten about a long-ago lousy investment). Meanwhile, management is still collecting fees. While the funds may now be something of a joke, their performance isn't, at least not to anyone who has lived through it.

Isn't it less expensive to invest in an exchange-traded fund than an ordinary mutual fund that tracks the same index?

- Alan (no town given)

The answer depends not only on the funds involved, but on the habits of the investor. If you invest big slugs of money and seldom add to it or take withdrawals, the exchange-traded fund may be cheapest, but if you invest at regular intervals - or plan to withdraw money every few months as needed - chances are the traditional fund is best.

While exchange-traded funds typically have a lower expense ratio than funds based on the same index, the difference can be tiny; the Vanguard Total Stock Market Index fund (VTSMX) is just 0.06 percentage points more expensive than Vanguard's ETF product based on the same index (ticker VTI). On a $10,000 investment, you're talking a difference of six bucks a year.

But exchange-traded funds are traded like stocks, so there are commissions involved in buying and selling. If your discount broker charges $6 a trade, the ETF only comes out ahead if you hold it more than two years (one to make up the buying commission and the other when you sell). The higher the commission, the longer the holding period needed to come out ahead.

Of course, ETFs are built to be traded, and they don't have short-term redemption fees, so if you're planning a quick in-and-out, they may turn out best.

The bottom line: Know the way you plan to invest and do the math; don't pick a fund in order to save a few pennies if it will wind up costing you a few dollars.

Charles Jaffe writes for MarketWatch. He can be reached by mail at Box 70, Cohasset, MA 02025-0070.

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