by Archie M. Richards, Jr., CFP^®
May 23, 2005

A mutual fund is a pooling of money invested by thousands of investors. The fund enables participation in the performance of a single portfolio managed by investment professionals.

Most mutual funds are corporations whose shares are owned by the investors. The more money invested, the more shares the investor owns.

The shares of stock owned by the mutual fund are different from the shares of stock of the mutual fund owned by its investors.

Some mutual funds own stocks; others bonds. "Balanced funds" own both.

Assume that the value of all the securities owned by a fund is $100 million and that the number of shares of the fund owned by its investors is 10 million. Each share would represent $10 of value ($100/10). That's called the "Net Asset Value" - NAV for short.

Investors report their share of interest, dividends, and gains on their individual tax returns. Funds cannot pass through losses.

The most common type of mutual fund is "open-end funds." Buyers of shares acquire them from the fund. To accommodate buyers, the fund creates new shares. To accommodate sellers, the shares cashed in simply disappear. The number of shares outstanding fluctuates every day according to demand. As a result, the price of the fund is always equal to the Net Asset Value.

A less common type of fund is "closed-end funds," most of which hold bonds. Here, the number of shares owned by investors remains fixed. Buyers cannot acquire shares from the fund. They must buy them through a broker from other investors who want to sell. Sellers of closed-end funds must, through brokers, find other parties who want to buy.

Since the number of shares of close-end funds does not fluctuate according to demand, the price of the fund is seldom equal to the Net Asset Value. The price normally stands at a premium above the NAV or a discount below it - usually the latter.

Shares of closed-end funds first get into the hands of investors through an initial public offering (IPO). Thereafter, the shares trade from one investor to another, in many cases via the New York Stock Exchange.

The objectives of a fund and all pertinent information about it is disclosed in the fund's "prospectus." This you should read before buying. If you don't understand the prospectus, ask questions. Otherwise, look for another fund whose prospectus you do understand.

The most important feature of mutual funds is diversification - an essential factor in successful investing.

Mutual funds make investing easy. You can arrange (and should arrange) for a fund to withdraw a certain amount from your bank account on a monthly or quarterly basis. As the money is earned, a portion is invested automatically.

At your direction, a fund can also make withdrawals on a regular basis, depositing the money directly into your bank account.

Each business day, funds deduct from their portfolios a portion of the annual costs of operation. The annual total of these fees is given in the prospectus.

If you buy shares of a fund through a brokerage firm, sales charges are also incurred. The manner in which these are charged is determined by the "Class" of shares you buy. The charges are explained in the prospectus. To avoid sales charges altogether, buy a "no-load" mutual fund directly from the fund.

Trading is expensive. Unfortunately, funds do not disclose trading costs in their prospectuses. But they do disclose the rates of turnover of their securities. If the turnover is 100 percent, for example, the fund in effect has replaced all of its holdings during the year. For the average fund these days, the turnover rate is approximately 80 percent, which is way too high.

Costs make a difference. Stick to funds whose annual costs are 0.5 percent or lower, with turnover rates of 40 percent or less.