‘No-Frills’ Prospectus Rule Brings New Risks

Mutual funds are not supposed to be an impulse buy.

Sure, you can call for a prospectus and mail-order an account almost as easily as you can shop from the Talbots catalog, but you aren’t buying so much as becoming an owner.

That distinction--along with the risks inherent in any investment--are why government regulators decided a few years ago not to allow “off-the-page sales,” in which advertisers include account applications in their promotions. The ads-cum-applications would have enabled purchases without so much as a sniff of the prospectus.

Instead, the Securities and Exchange Commission argued that the industry needed to clean up their prospectuses, put them in plain English, and create summary or profile documents that give investors the necessary details in an easy-to-read format.

The regulators won. The profile prospectus is now approved for general use, and every fund is required to develop a full “plain English” prospectus by this fall.

But the victory created an opening for fund companies to make an end run around regulations, and it looks as if the face of fund advertising could change forever before this year is out.

Here’s how: The profile prospectus--which gives a no-frills version of what the fund does and how consumers are charged--can be reprinted on one page of an ad spread. On the next page, fund sponsors can place a little ad that hypes performance, just above an application form. Bind it together with a postage-paid envelope and you have off-the-page advertising, the very thing that regulators said was not good for consumers.

And all indications are that this is completely legal so long as the prospectus is there. On the application, the consumer acknowledges receiving the profile prospectus.

“The industry has skillfully played the regulators to get exactly what it wants,” said Don Phillips, president of Morningstar Inc., the Chicago fund research firm. “It now looks as if the regulators have created a vehicle that allows the very activity they have described as inappropriate.”

To date, the new ads exist only in prototypes, but Edward C. Frey, the publisher of Mutual Funds magazine, recently promoted the idea at the annual meeting of the Investment Company Institute and clearly believes that some fund company will take the plunge in the next few months.

“There is off-the-page selling in other countries, and the fund companies use it to great success,” Frey said. “Instead of placing an ad and five days later just having a lot of requests for prospectuses, they see real cash coming in the door. They also cut down expenses by not having to convince the people making inquiries to actually become shareholders.”

OK, so the industry may save some trees. The question is whether consumers will lose their shirts.

Already people can buy funds without seeing a prospectus. Simply look at any ad that has the 800 number for a fund supermarket such as Schwab’s OneSource or Fidelity’s FundsNetwork. People with established accounts can call those numbers and place orders. And despite claims that prospectuses are always sent in advance, everyone in the industry agrees that plenty of those direct orders are made before a prospectus is sent.

Of course, consumers long have been able to buy stocks without seeing any type of legal document. And many consumers simply ignore the prospectus altogether, which is what prompted the push for change. The idea was to come up with something--anything--consumers would read.

The problem with any change that trivializes the prospectus and speeds up the investment process is that it removes the substance of decision-making. It encourages a gold-rush mentality in which a good record is used to attract cash regard to whether the investor has the means to make an appropriate choice.

The investor who can buy on a whim can just as easily bail out at the first sign of trouble. That’s bad for the investor, who suffers severe tax consequences for quick turnarounds and whose short-term maneuverings can sabotage long-range plans. But it’s also bad for the rest of the investors in a fund, because big purchase and redemption swings are tricky--a lot more difficult to manage than steady cash flows.

“There is an element of pre-qualifying that needs to take place in fund purchases so that the right investor is in the right kind of fund,” said Stephen M. Savage, executive director of the Value Line Mutual Fund Survey. “That makes for stable relationships, which are good for everyone.

“If the system changes so that people get caught up in an ad that looks really impressive and buy on impulse, we could see a lot more people dissatisfied with their funds.”

No matter how fund ads evolve, don’t make impetuous investment decisions. Funds aren’t like mail-order clothing. There are no easy-return policies, and there is a big price to pay for picking the wrong style, color and fit for you.

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Charles A. Jaffe is the mutual funds columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, P.O. Box 2378, Boston, MA 02107-2378.