How Could I Lose in This Fund? Let Me Count the Ways. Pros suggest how to make sense of lengthy risk disclosures

How Could I Lose in This Fund? Let Me Count the Ways.

Pros suggest how to make sense of lengthy risk disclosures

VERONICA DAGHER

Updated Dec. 4, 2013 4:01 p.m. ET

What could go wrong when you invest in a mutual fund? Apparently a lot, if you read fund-company disclosures. Fund firms have a legal duty to disclose the risks associated with their products. So just like drug companies’ disclaimers that tell in horrifying detail all of the possible side effects of a medication, fund companies offer an extensive litany of the many ways an investment could go awry.The problem, though, is that in listing everything that could possibly go wrong—no matter how generic the risk or remote the possibility—fund companies make it hard for investors to identify what is reallyimportant.

For example, some mutual funds and exchange-traded funds and notes list more than a dozen risks, citing everything from the ultra-obvious—”You could lose money in the fund”—to the utterly confusing: “The risk that securities purchased pursuant to an arbitrage strategy intended to take advantage of a perceived relationship between the value of two securities may not perform as expected.”

Add in country risk, subsidiary risk, convertible-securities risk, management risk and currency risk, to name a few, and you’ll likely have an anxious investor (unless, of course, the list puts the person to sleep).

A modern-day prospectus is a “Frankenstein’s monster” filled with generic risk-disclosure information written by lawyers to protect companies from litigation, says Daniel Kern, chief investment officer at Advisor Partners in Walnut Creek, Calif. The prospectus rules call for disclosure of a fund’s “principal” risks. But “with each new problem in the industry, a lawyer somewhere thinks of a new disclosure to be added,” says Mr. Kern.

Some disclosures are painfully obvious, says Mr. Kern. One of his favorites is when funds warn of “equity risk,” or the fact that stocks rise and fall daily.

Attorney Stephen Bier, a partner at Dechert LLP in New York, says “a kitchen-sink approach to risk disclosure isn’t helpful to investors.” Yet financial firms are in a bind, he says. “Even if a risk may be viewed as remote at the time an investment is being made, unanticipated things can and do happen,” he says. “There is a worry that a plaintiff’s lawyer or regulator could view the adequacy of the risk disclosure with 20-20 hindsight.”

Since the 2008 financial crisis, risks that previously might have been viewed as secondary, like that of a trading counterparty going bankrupt, are more likely to be highlighted, he says.

How can investors make smart use of a fund’s risks list? Mr. Kern recommends investors scan the risk section to identify risk factors that don’t fit their understanding of the fund’s strategy. For example, if they are considering a fund that they think will primarily own U.S. stocks, extensive risk disclosures about foreign exposure and emerging-markets and political risk could signal the need for closer investigation.

Samuel Lee, editor of ETFInvestor at Morningstar Inc., MORN +0.01% says lengthy risk disclosures can be a reminder of the value of plain-vanilla investments. “Complicated products apt to blow up tend to have long disclosures written in legalese to provide cover when the inevitable occurs,” he says. Simple, solid products tend to have short, easily understood disclosures, such as that of the Vanguard 500 Index fund, he says.

But Tim McCarthy, an industry consultant to asset managers, says a fund might give a long list of risks because it spreads investors’ money across stocks, bonds and other assets, each with its own hazards. That diversification might actually make the fund less risky than one that focuses on only one asset class, he says.