HOW MUTUAL FUNDS WORK

A large number of people with money to invest buy shares in a mutual fund Their pooled money has more buying power The fund manager invests the money in a collection of stocks, bonds, or other securities Successful investment adds value to the fund Investors receive distributions

Most investment professionals agree that it's smarter to own a variety of stocks and bonds than to gamble on the success of a few. But diversifying can be tough because buying a portfolio of individual stocks and bonds can be expensive. And knowing what to buy — and when — takes time and concentration.

Mutual funds offer one solution: When you put money into a fund, it's pooled with money from other investors to create much greater buying power than you would have investing on your own.

Since a fund can own hundreds of different securities, its success isn't dependent on how one or two holdings do. And the fund's professional managers keep constant tabs on the markets, working to adjust the portfolio for the strongest possible performance.

But you take certain risks when you put your money into mutual funds, as you do with any investment. The return may be less than you had expected, and the value of your account could decline.

PAYING OUT THE PROFITS
A mutual fund makes money in two ways: by earning dividends or interest on its investments and by selling investments that have increased in price. The fund distributes, or pays out, its profits (minus fees and expenses) to its investors.

Income distributions are from the money the fund earns on its investments. Capital gain distributions are the profits from selling investments. Different funds pay their distributions on different schedules — from once a day to once a year. Many funds offer investors the option of reinvesting all or part of their distributions to buy more shares in the fund.

You pay taxes on the distributions you receive from the fund, whether the money is reinvested or paid out in cash. But if a fund loses more than it makes in any year, it can use the loss to offset future gains. Until profits equal the accumulated losses, distributions aren't taxable, although the share price may increase to reflect the profits.

CREATING A FUND
Mutual funds are created by investment companies (called mutual fund companies), brokerage houses, and banks. The number of funds an investment company offers varies widely, from as few as two or three to over 150.

Each fund has a professional manager or team of managers, an investment objective, and a plan, or investment program, the manager follows in building the fund portfolio. The funds are marketed to potential investors with ads in the financial press, through direct mailings and press announcements, and in some cases with the support of registered representatives who make commissions selling them.

OPEN- AND CLOSED-END FUNDS
Most mutual funds are open-end funds. That means the fund sells as many shares as investors want. As money comes in, the fund grows. If investors sell, the fund buys their shares back. Sometimes open-end funds are closed to new investors when they grow too large to be managed effectively — though current shareholders can continue to invest money. When a fund is closed this way, the investment company often creates a similar fund to capitalize on investor interest.

Closed-end funds more closely resemble stocks in the way they are traded. While these funds do invest in a variety of securities, they raise money only once, offer only a fixed number of shares, and are traded on an exchange or over the counter (OTC). The market price of a closed-end fund fluctuates in response to investor demand as well as to changes in the value of its holdings.

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