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Dr. Don TaylorA primer on mutual funds

Dear Dr. Don,
What exactly is a mutual fund, and how does it work?
-- Rebecca Return

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Dear Rebecca,
When you buy shares in a mutual fund, you are buying ownership interest, or shares, in an investment company. The company uses your money to invest in financial assets. The purchase and sale of these financial assets is managed by a professional investment manager. The value of your shares varies with changes in the value of the investments. At the end of each business day, the fund values its assets and divides that number by the number of shares to arrive at the fund's net asset value.

Mutual funds can be segregated by what they invest in, their fee structure and whether they are closed- or open-end funds. Closed-end funds limit the number of shares outstanding, and open-end funds can grow in size as money comes into the fund. Vanguard's 500 Index, for example, is a large open-end fund with a net asset value of more than $100 billion dollars. Investing in closed-end funds is a bit more complex than investing in open-end funds for the beginning investor, so my remaining comments will focus on open-end mutual funds.

Mutual funds typically invest in some combination of stocks, bonds and cash. A mutual fund that invests only in short-term debt instruments with a final maturity of a year or less is a money-market mutual fund. Mutual funds that invest in both bonds and stocks are called "hybrid funds." Mutual funds that track a market index, as the Vanguard 500 Index Fund does with the Standard & Poor's 500 Index, are called "index funds."

Bond funds vary by types of bonds, i.e., government, agency, corporate, municipal, foreign and emerging markets, and by the target maturity of the debt in the fund. Stock funds can vary by the size of the companies the fund invests in, i.e., small-capitalization, mid-cap and large-cap stocks, the industry or sector of the companies and whether the stocks are growth stocks or value stocks.

Mutual fund shareholders pay fees and expenses to invest in these funds. The mutual-fund investor has to decide between investing in a no-load mutual fund or a mutual fund that charges a sales load or commission. Paying a sales load is one way to compensate your financial adviser for his advice. It doesn't affect how the funds are invested or how the investment manager gets compensated. The investment manager earns a separate management fee for that work. Sales loads can be front-loaded, back-loaded (redemption fees) or pay-as-you-go. You can typically choose between these approaches when you buy a load mutual fund. The Bankrate feature, "The ABCs of mutual fund fees," has more about load mutual funds, as does this earlier Dr. Don column.

Marketing fees are a separate charge with no-load mutual funds. Called 12b-1 fees, they are added to the annual management fees to arrive at the annual expense ratio for a mutual fund.

My rule of thumb for investors just starting out is to concentrate your investment in a diversified fund rather than diversifying your investment in concentrated funds. Starting out in one or two broadly based no-load index funds is a low cost, efficient way to start investing. You can contact a no-load mutual fund directly to invest in that fund, or you can work with a financial services professional who will help you select a fund or funds.

Bankrate offers a tutorial called Investing Basics that can help you learn more about the basics of investing in mutual funds. Good luck. You can do this.

Editor's Note: Dr. Don owns shares in Vanguard 500 Index.

-- Posted: July 11, 2005




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