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					MUTUAL FUND BASICS
MUTUAL FUND BASICS .......................................................................................................................................1 Overview: ..................................................................................................................................................................2 Basics:........................................................................................................................................................................2 Closed Vs Open Ended Funds: ..................................................................................................................................2 Load Vs No Load Funds: ...........................................................................................................................................3 Types Of Funds: ............................................................................................................................................................4 Equity Mutual Funds: ................................................................................................................................................4 Large And Small Cap Funds: ....................................................................................................................................4 Growth And Value Funds: .........................................................................................................................................5 Index Funds Essentials: .............................................................................................................................................6 Sector Funds: .............................................................................................................................................................6 Foreign Stock Funds: .................................................................................................................................................7 Bond Funds Explained:..............................................................................................................................................7 Money Market Funds Explained: ..............................................................................................................................8 Unit Investment Trusts: .............................................................................................................................................8 Fund Strategies: .............................................................................................................................................................9 How To Build A Mutual Fund:..................................................................................................................................9 Spiders: .................................................................................................................................................................... 10 Cost Control:............................................................................................................................................................ 10 Tax Efficient Investment: ........................................................................................................................................ 11

Overview:
Basics:
Once you've decided to invest in the stock market, mutual funds are an easy way to own stocks without worrying about choosing individual stocks. As an added bonus, you can find plenty of information on the Internet to help you learn about, study, select, and purchase them. But what is a mutual fund? It's not complicated. A dictionary definition of a mutual fund might go something like this: a single portfolio of stocks, bonds, and/or cash managed by an investment company on behalf of many investors. The investment company is responsible for the management of the fund, and it sells shares in the fund to individual investors. When you invest in a mutual fund, you become a part owner of a large investment portfolio, along with all the other shareholders of the fund. When you purchase shares, the fund manager invests your funds, along with the money contributed by the other shareholders. Every day, the fund manager counts up the value of all the fund's holdings, figures out how many shares have been purchased by shareholders, and then calculates the Net Asset Value (NAV) of the mutual fund, the price of a single share of the fund on that day. If you want to buy shares, you just send the manager your money, and they will issue new shares for you at the most recent price. This routine is repeated every day on a never-ending basis, which is why mutual funds are sometimes known as "open-end funds." If the fund manager is doing a good job, the NAV of the fund will usually get bigger -- your shares will be worth more. But exactly how does a mutual fund's NAV increase? There are a couple of ways that a mutual fund can make money in its portfolio. (They're the same ways that your own portfolio of stocks, bonds, and cash can make money).  A mutual fund can receive dividends from the stocks that it owns. Dividends are shares of corporate profits paid to the stockholders of public companies. The fund might have money in the bank that earns interest, or it might receive interest payments from bonds that it owns. These are all sources of income for the fund. Mutual funds are required to hand out (or "distribute") this income to shareholders. Usually they do this twice a year, in a move that's called an income distribution.  At the end of the year, a fund makes another kind of distribution, this time from the profits they might make by selling stocks or bonds that have gone up in price. These profits are known as capital gains, and the act of passing them out is called a capital gains distribution. Unfortunately, funds don't always make money. If the fund managers made some investments that didn't work out, selling some investments for less than the original purchase price, the fund manager may have some capital losses. Everyone hates to have losses, and funds are no different. The good news is that these losses are subtracted from the fund's capital gains before the money is distributed to shareholders. If losses exceed gains, a fund manager can even pile up these losses and use them to offset future gains in the portfolio. That means that the fund won't pass out capital gains to shareholders until the fund had at least earned more in profits than it had lost. (Although you might want to reconsider your decision to remain invested in a fund that's losing money if the rest of the market is growing).

Closed Vs Open Ended Funds:
Like load vs. no load, you'll hear mutual fund people divide their universe between open-end and closed-end funds. Here's what it means: Open and closed-end funds are both pools of investor money and they are both managed by professionals to maximize diversification within a set strategy. The difference is in how the fund is structured in terms of ownership. An open-end fund issues and redeems shares on demand, whenever investors put money into the fund or take it out. This happens routinely every day and the total assets of the fund grow and shrink as money flows in and out. That means the more investors buy the Vanguard 500 Index fund, for instance, the more shares there will be. There's no limit to the number of shares the fund can issue. Nor is the value of each individual share affected by the number outstanding, since net asset value (NAV) is determined solely by the change in prices of the stocks or bonds the fund owns, not the size of the fund itself.

A closed-end fund is a different animal. Like a company, it issues a set number of shares in an initial public offering and they trade on an exchange. A fund like France Growth Fund trades on the New York Stock Exchange just like any other stock. Its share price is determined not by the total value of the assets it holds, but by investor demand for the fund. Investing in closed-end funds can be very confusing for the novice investor and we don't recommend it. Since these funds are traded on the open market, most sell at a discount to their underlying asset value for a number of reasons. Most investors who buy closed-end funds look for those with solid returns that are trading at large discounts. They bet that the spread between the discount and the underlying asset value will close. If you don't understand the mechanics of evaluating the discount spread, however, you're better off sticking to open-end funds.

Load Vs No Load Funds:
Let's first review the different types of mutual fund structures. Load funds charge a commission while no-load funds are commission-free. The structure of load funds can be (1) front-end with the commission varying from 3 to 6.25 percent of the investment, or (2) back-end, also known as redemption, with the commission usually at 3 percent of asset value when sold. In addition, pratically all load funds charge annual distribution fees, also referred to as 12b-1 fees, which are used to pay for pro motional costs. These costs vary from 0.25 to 0.75 percent of annual asset value. Some no-load funds also charge 12b-1 fees, but no-load funds that do not charge 12b-1 fees are known as 100 percent no-load or true no-load. Is there really that much of a worthwhile difference between load and no-load funds? An analogy to comparing mutual fund structures would be a one-hundred yard race. If the race competitors have equal ability, but one has a five to six yard head start, yo u obviously know who would win the contest. In fact, the one with the head start would only lose to a competitor with far superior ability. In the mutual fund illustrations below, assume all "competitors" have equal ability in order to accurately demonstr ate the differences in performance. Assuming a $10,000 investment with a conservative nine percent annual net return rate (after annual fund operating expenses) over three years, the following illustrations compare the differences in total return and Return on Investment (ROI) among three d ifferent types of mutual fund sales structures:  100% no-load (no 12b-1 fees)  5% front-end load with 0.5% per year 12b-1 fees  3% back-end load with 0.5% per year 12b-1 fees (redemption in year 3)  Total Return Comparison Start Year 1 Year 2 Year 3 $10,000 $10,900 $11,881 $12,950 100% No-Load $ 9,500 $10,303 $11,174 $12,119 5% Front-End Load $10,000 $10,845 $11,762 $12,374 3% Back-End Load Cumulative ROI Comparison Year 1 Year 2 Year 3 9.0% 18.8% 29.5% 100% No-Load 3.0% 11.7% 21.2% 5% Front-End Load 8.4% 17.6% 23.7% 3% Back-End Load In cumulative ROI after three years in this illustration, the 100 percent no-load fund outperforms the five percent front-end load fund by 39.3 percent and the back-end load fund by 24.4 percent -- even though a nine percent annual return rate is ident ical for all three funds! The ROI advantage of the 100 percent no-load fund in this illustration is due entirely to the absence of both sales load and annual 12b-1 distribution fees. The advantage of the 100 percent no-load fund in these illustrations is very apparent. Com parative ROI differences would be even more dramatic as the annual return rate parameter falls below nine percent, less dramatic as the annual return rate parameter rises above nine percent. Does this imply that all no-load funds are superior to all load funds? Of course not. Obviously, a five percent frontend load fund with a 15 percent annual return will outperform a no-load fund with a nine percent annual return. However, no-load funds th at carry above average rankings (from Morningstar or Lipper) will most likely

outperform load funds, provided that the funds are in the identical fund category (i.e.; growth, growth & income, global, corporate bond) with a time frame of at least three years. Finally, you should be aware of custodial fees or managerial fees. Recently, a major brokerage firm announced that it would be offering no-load funds from 28 fund families without charging commissions or 12b-1 fees. However, this firm will compensate sale smen by charging clients up to 1.5 percent of their assets on an annual basis. Over a relatively short time, these fees would be substantially greater than even a five percent front-end load! It is best to avoid these types of fees and maintain the no-load advantage.

Types Of Funds:
Equity Mutual Funds:
Most mutual funds invest in stocks, and these are called equity funds. While mutual funds most often invest in the stock market, fund managers don't just buy any old stock they find attractive. Some funds specialize in investing in large-cap stocks, others in small-cap stocks, and still others invest in what's left -- mid-cap stocks. "Cap" has nothing to do with hat size or what your spouse left off the tube of toothpaste (again). On Wall Street, cap is shorthand for capitalization, and is one way of measuring the size of a company -- how well it's capitalized. Large-cap stocks have market caps of billions of dollars, and are the best-known companies in the U.S. Small-cap stocks are worth several hundred million dollars, and are newer, up-and-coming firms. Mid-caps are somewhere in between. Mutual funds are often categorized by the market capitalization of the stocks that they hold in their portfolios. But how big is a large cap stock? Formulas differ, but here is one guideline: Small-cap stocks < $500 million Mid-cap stocks $500 million to $5 billion Large-cap stocks > $5 billion Equity fund managers usually employ one of three particular styles of stockpicking when they make investment decisions for their portfolios. Some fund managers use a value approach to stocks, searching for stocks that are undervalued when compared to other, similar companies. Often, the share prices of these stocks have been beaten down by the market as investors have become pessimistic about the potential of these companies. Another approach to picking is to look primarily at growth, trying to find stocks that are growing faster than their competitors, or the market as a whole. These funds buy shares in companies that are growing rapidly -- often well known, established corporations. Some managers buy both kinds of stocks, building a portfolio of both growth and value stocks. This is known as the blend approach.

Large And Small Cap Funds:
STOCK FUNDS are often grouped by the size of the companies they invest in -- big, small or tiny. By size we mean a company's value on the stock market: the number of shares it has outstanding multiplied by the share price. This is known as market capitalization, or cap size. Big companies tend to be less risky than small fries. But smaller companies can often offer more growth potential. The best idea is probably to have a mix of funds that give you exposure to large-cap, midsize and small companies. For more detail on how these different types of stocks behave, take a look at our Stocks department. Large-Cap Funds Large-capitalization funds generally invest in companies with market values of greater than $8 billion. Some, like the Vanguard 500 Index fund, merely mimic the index and invest in all 500 companies. Others, like Fidelity's huge Magellan fund, try to beat the index by picking a mix of large caps that will outperform the broader market. As you can see from the applet at the right, large-cap funds are less volatile than funds that invest in smaller companies. Usually, that means you can expect smaller returns, but lately, large caps have outperformed all others. The last few years of the 1990s dished up an odd combination of economic stability in the U.S., but turmoil in Asia, Latin America and Russia. That made the stock market extremely volatile and convinced many investors to run for the relative stability of large, established companies like General Electric and Microsoft.

That may not always be the case, but for most investors, a large-cap fund is their core long-term holding, anyway. A good one is a reliable -- but far from stodgy -- place to park your retirement savings. Mid-Cap Funds As the name implies, these funds fall in the middle. They aim to invest in companies with market values in the $1 billion to $8 billion range -- not large caps, but not quite small caps, either. The stocks in the lower end of their range are likely to exhibit the growth characteristics of smaller companies and therefore add some volatility to these funds. They make the most sense as a way to diversify your holdings. Small-Cap Funds A small-cap fund, like Turner Small Cap Equity, will focus on companies with a market value below $1 billion. The volatility of the fund often depends on the aggressiveness of the manager. Aggressive small-cap managers will buy hot growth and technology companies, taking high risks in hopes of high rewards. More conservative "value" managers will look for companies that have been beaten down temporarily by the stock market. Value funds aren't as risky as the hot growth funds, but they can still be volatile. Because of their volatility, small-cap funds require that you have enough time to make up for short-term losses. And as we saw during 1997 and 1998, there are times when the market turns away from small-cap companies altogether for extended periods. (Large caps have taken the spotlight lately due to extreme volatility in the markets; small caps, meanwhile, have floundered.) But that's no reason to abandon these funds. History would indicate that small companies will eventually regain favor as markets settle down. And when they do, they will likely grow more quickly than their larger cousins -which can provide a good kicker for aggressive investors who need to build as much wealth as possible while they're young. Micro-Cap Funds We're talking small fries here -- companies with market values below $250 million. These funds tend to look for either startups, takeover candidates or companies about to exploit new markets. With stocks this small, the volatility (read risk) is always extremely high, but the growth potential is exceptional. Bridgeway Ultra-Small Company, for instance, sported a three-year average annual growth rate of 15.9% at the end of 1998, but in August, it had just come off a 13-week stretch in which it lost 22.8%. If you have the time and inclination to pay attention to a fund like this, you might be willing to put some money in. But beware: Micro-cap funds can rear up and bite you.

Growth And Value Funds:
EVERY MANAGER is different, but there are three broad archetypes when it comes to investment strategy: growth, value and blend. The issue here is whether the manager a. is willing to chase popular (a.k.a. expensive) stocks, hoping to cash in on their momentum; or b. is seeking to "discover" cheap stocks, betting that the market will discover them, too. Growth Funds As their name implies, these funds tend to look for the fastest-growing companies on the market. Growth managers are willing to take more risk and pay a premium for their stocks in an effort to build a portfolio of companies with above-average earnings momentum or price appreciation. For example, Dell and Microsoft are generally considered "expensive" stocks, because their prices have been bid high relative to their profits. But because they enjoy vibrant markets and have rapid earnings growth, managers like Scott Schoelzel of Janus Twenty have no qualms paying big prices. Schoelzel knows that investors crave these super-charged growth stocks and will keep piling into them as long as the growth keeps up. But if the growth slows, watch out -- the more momentum a stock has, the harder it is likely to fall when the news turns bad. That's why growth funds are the most volatile of the three investment styles. It's also why expenses and turnover (which leads to tax liability) are also higher. For these reasons, only aggressive investors, or those with enough time to make up for short-term market losses, should buy these spooky funds. Value Funds These funds like to invest in companies that the market has overlooked. Managers like Marty Whitman of Third Avenue Value search for stocks that have become "undervalued" -- or priced low relative to their earnings potential. Sometimes a stock has run into a short-term problem that will eventually be fixed and forgotten. Or maybe the company is too small or obscure to attract much notice. In any event, the manager makes a judgment that there's more potential there than the market has recognized. His bet is that the price will rise as others come around to the same conclusion.

Whitman, for instance, bought real-estate insurance company First American Financial early in 1997 before it was discovered by the Street. The stock rose 96% in 1998 and still traded at just 9.5 times the past 12-month earnings -a steal when you consider the market average at the time was more like 22 times earnings. The big risk with value funds is that the "undiscovered gems" they try to spot sometimes remain undiscovered. That can depress results for extended periods of time. Volatility, however, is quite low, and if you choose a good fund, the risk of doggy returns should be minimal. Also, because these fund managers tend to buy stocks and hold them until they turn around, expenses and turnover are low. Add it up, and value funds are most suitable for more conservative, tax-averse investors. Blend Funds These can go across the board. They might, for instance, invest in both high-growth Internet stocks and cheaply priced automotive companies. As such, they are difficult to classify in terms of risk. The Vanguard 500 Index fund invests in every company in the S&P 500 and could therefore qualify as a blend. But because it's also a large-cap fund, it tends to be steady. The Legg Mason Special Investment fund is more aggressive, with heavy weightings in technology and financials. In order to determine if a particular blend fund is right for your needs, you'll probably have to look at the fund's holdings and make a call.

Index Funds Essentials:
An index fund allows you to enjoy the good parts of a mutual fund, with little or none of the bad, by buying stock in all the companies of a particular index and thereby reproducing the performance of an entire section of the market. An index fund builds its portfolio by simply buying all the stocks in a particular index -- the fund buys the entire stock market, not just a few stocks. The most popular index of stock index funds is the Standard & Poor's 500, but there are index funds that track 28 different indexes, and more are added all the time. An S&P 500 stock index fund owns 500 stocks -- all the companies that are included in the index. This is the key distinction between stock index funds and "actively managed" mutual funds. The manager of a stock index fund doesn't have to worry about which stocks to buy or sell -- he or she only has to buy the stocks that are included in the fund's chosen index. A stock index fund has no need for a team of highly-paid stock analysts and expensive computer equipment that goes into picking stocks for the fund's portfolio. So the hard part about running a mutual fund is gone. Investing in stock index funds is often called passive investing, since the funds don't use the same active management techniques as other funds. Passive investing has two big advantages over active investing. First, a passive stock market mutual fund is much cheaper to run than an active fund. Eliminate those analysts' salaries and an index fund can cut its costs tremendously -- and those savings can be passed along to investors in the form of higher returns. The second main advantage of stock index funds is that they perform better than actively managed funds. Some investors find it incredible when they learn that most mutual funds are flops, at least when it comes to generating returns for their shareholders. In 1998, for instance, 85 percent of all mutual funds that were set up to beat the S&P 500 failed to meet that goal. When you think about it, that's an amazing statistic -- eight out of ten mutual funds didn't beat the market! Of course, investing in a stock index fund guarantees that you'll never outperform the overall market, but less than 20 percent of all professional mutual fund managers master that task in any given year. Even armed with this knowledge, some investors are convinced that they can pick out one of the funds that will be in the rare 20 percent club -- easy in theory but actually much harder in practice. If you looked at lists of the top-performing mutual funds for the last several years, you won't likely find many of the same names on more than a few of them. It's not uncommon for a fund to have a "hot" year, but it's very uncommon for a fund to consistently turn in above average performance.

Sector Funds:
Sector Funds do what their name implies: They restrict investments to a particular segment -- or sector -- of the economy. A fund like Northern Technology, for instance, only buys tech companies for its portfolio. Munder NetNet cuts it even finer by holding only Internet-related stocks. Fidelity has a whole stable of sector funds from Fidelity Select Insurance to Fidelity Select Automotive. The idea is to allow investors to place bets on specific industries or sectors whenever they think that industry might heat up.

While such a strategy might appear to throw diversification to the wind, it doesn't entirely. It's true that investing in a sector fund definitely focuses your exposure on a certain industry. But it can give you diversification within that industry that would be hard to achieve on your own. How? By spreading your investment across a broad representation of stocks. Of course, such concentrated portfolios can produce tremendous gains or losses, depending on whether your chosen sector is in or out of favor. In 1998, for instance, Northern Technology soared 83% because Internet and computer companies were hot. Precious-metals specialist Scudder Gold, meanwhile, plummeted 16.7% because gold and silver plunged. Because of this specialization, any sector fund carries more risk than a generalized fund. But some sectors are clearly more volatile than others. For example, Vanguard Utilities, which invests in staid electrical companies, has about one-third the volatility of Merrill Technology, which buys supercharged software makers.

Foreign Stock Funds:
Since the economies of the world's different regions tend to boom and bust in cycles that offset each other, international stocks can provide excellent diversification for a portfolio heavy on U.S. equities. And a fund with a good manager is often the best way to go, because research is scarce and foreign companies are notoriously hard for individual investors to track on their own. Foreign-stock funds allow you exposure to overseas markets at varying levels of risk. Some are fairly tame. Others can make your hair stand on end. Consider the experience of the summer of 1998, when the Asian economies fell like dominoes and plundered stocks in the region. Funds like Pioneer Emerging Markets and Ivy Developing Nations, with heavy exposure to Asia, got hammered. Even when foreign economies are doing reasonably well, currency fluctuations can have a negative effect on stock prices. Of course, economic and currency risk can also swing very strongly in a positive direction. So, as always, diversification is the key to managing risk. Funds investing overseas fall into four basic categories: global, international, emerging market and country specific. The wider the reach of the fund, the less risky it is likely to be. Global Funds Global funds are the most diverse of the four categories. But don't be fooled by their cosmopolitan-sounding name. They're able to invest in any region of the world, including the U.S., so they don't actually offer as much diversification as a good international fund. A prime example: Idex Global, which is 26% invested in the U.S., 11% in Britain, 8% in France, 6% in Japan and 6% in Germany. Global funds tend to be the safest foreign-stock investments, but that's because they typically lean on better-known U.S. stocks. International Funds These funds invest most of their assets outside the U.S. Depending on the countries selected for investment, international funds can range from relatively safe to more risky. Fidelity Diversified International, for instance, has its assets spread over 44 different countries, many of which are in Europe. Oakmark International Small Cap, on the other hand, has significant exposure to some of the most volatile regions in the world: Thailand, South Korea, Hong Kong and Turkey. The best thing to do is to choose a fund with the best balance, or make damn sure the manager has done a good job of moving in and out of regions profitably. Country-Specific Funds These funds invest in one country or region of the world. That kind of concentration makes them particularly volatile. If you pick the right country -- Britain in 1998, for example -- the returns can be substantial. But pick the wrong one, and watch out. Only the most sophisticated investors should venture into this territory. Emerging-Market Funds Emerging-market funds are the most volatile. They invest in undeveloped regions of the world, which have enormous growth potential, but also pose significant risks -- political upheaval, corruption and currency collapse, to name just a few. Don't go near these funds with anything but money you are willing to lose.

Bond Funds Explained:
To understand how bond funds work, you should really visit our Bonds section. But we'll touch on them here. Bond funds are designed to give your portfolio its recommended dose of fixed-income investments so you don't have to go through the hassle of buying bonds yourself. These, too, come in various types. Term Funds All bonds are structured so you get paid your principal after a set amount of time. They're either short, intermediate

or long term, depending on the number of years until they mature. Bond funds are the same way. A fund like Scudder Short-Term Bond is typical of its class, buying a mixture of corporate and government bonds with durations between one and 3.5 years. Intermediate funds like Stein Roe Intermediate range between 3.5 and 10 years, while Vanguard Long-Term Corporate only buys bonds with durations greater than six years. Generally speaking, the longer the duration, the higher the risk and reward. Why? Because the longer you hold a bond before it matures, the greater the chance its value could be adversely affected by changes in interest rates. As a result, whatever company or government issued the bond has to promise a higher yield upfront. Municipal Bond Funds Muni-bond funds invest in bonds issued by state municipalities. Some funds, like Eaton Vance National Municipal, invest in bonds offered throughout the country. Others, like Dreyfus New York Tax-Exempt Intermediate, invest in one state only. Tax breaks are the big draw of muni-bond funds. If you own a national fund, you are exempt from federal income taxes on any income you receive from the fund. If you live in the state specified in a state-specific fund, you are exempt from state and federal taxes. However, your lower taxes generally come with lower returns. Only investors in high tax brackets should buy these funds. High-Yield Bond Funds Bond funds invest in different grades of corporate bonds. High-yield, or "junk-bond," funds are the most wellknown of the bunch, because they offer the highest rates. Unfortunately, since these funds invest in low-grade corporate issues, they also entail the greatest risk. Companies with credit ratings of BBB or less are the most likely to default on their coupon payments. In another words, although the income may be high on a fund like Fidelity High Income, it's not guaranteed. Only the most risk-tolerant investors need apply.

Money Market Funds Explained:
Money-market funds are often touted as the safest kind of mutual fund, but that depends on your perspective. On the one hand, it's almost impossible to lose your principal in one of these things. On the other, their returns are so low -4% to 6% on average -- that they can't beat inflation over time. In the long term, your money loses its buying power and so actually becomes less valuable. Consequently, money-market funds are most useful for parking cash you need in the short term -- a car or house down payment, for instance, or next year's tuition. The reason money funds are so stable is because they invest in ultra short-term securities like those issued by banks, the federal government or big companies with Grade A credit ratings. Your return comes in the form of a dividend. In these respects, money-market funds are very similar to a bank certificate of deposit. The advantage of a money fund is that it is completely liquid. Unlike a CD, which will lock up your money for at least six months, you can sell your shares in a money fund at any time. They also often offer perks like the ability to write checks against the principal. The advantage of a CD is that your deposit is usually insured by the federal government. There are various types of money-market funds based on the type of securities they buy, but the most important distinction is whether your dividends are taxable or tax-free.

Unit Investment Trusts:
Unit investment trusts are investment companies that buy a specific portfolio of stocks, bonds, or other securities. They are cousins to mutual funds, but they have some fairly significant differences, too. First of all, UITs have fixed terms -- as short as a single year, or as long as 30 years or more. Mutual funds are ongoing operations that never expire. UITs generally buy and hold a fixed portfolio of stock, bonds, or other securities, often concentrated in a particular industry or sector. This is in marked contrast to mutual funds, which are required to adhere to certain rules of diversification and must hold a minimum number of different securities. UITs are not subject to those requirements, and so can own shares of stock in just a few companies. This is why there are no mutual funds that use a pure "Dogs of the Dow" approach. The "Dogs" strategy e ntails buying the ten highest yielding stocks in the Dow Jones Industrial Average, holding them for a year, and then repeating the process. Since a mutual fund can't own just ten different companies, a number of UITs have been created to implement the Do gs of the Dow strategy. Mutual funds can sell and buy shares frequently as long as those transactions meet the funds objectives stated in its prospectus. UITs cannot purchase or sell securities except in limited circumstances. In the case of one UIT, S&P Depositary Receipts (also known as SPDRs), the trust can replace securities only if they are replaced in the Standard & Poor's 500 Index -- and for no other reason.

Another difference between a trust and a mutual fund is that a trust doesn't generally generate capital gains to distribute to shareholders. Because the number of shares available in a UIT is fixed when the trust is created, investors who purchase shar es in a UIT after its initial offering buy them from other investors, and not from the sponsor, similar to a stock or closed-end fund. Because of the fixed number of shares of any particular UIT available in the market, buying and selling shares among investors does not carry tax consequences for other shareholders. In a mutual fund, a sell-off by shareholders could cause the fund to liquidate part of its holdings, and generate capital gains in the process. These taxable gains would be distributed to fundholders at year-end. In a UIT, shareholders generally incur capital gains or losses when they buy or sell their UIT shares. UITs do distribute dividend income to shareholders, either on a monthly or quarterly basis. There are over 12,000 unit investment trusts currently available in the U.S., each specializing in any of a number of investment objectives. There are UITS that own corporate bonds, international bonds, state or national municipal bonds, U.S government securities, mortgage-backed securities, and equities. Some UITs concentrate on specific sectors, or a particular investment strategy.

Fund Strategies:
How To Build A Mutual Fund:
Stick with stock funds. As long as you have five or more years until you need the money, stock funds will likely provide you with superior returns over any other investment. But you have to be patient. In the short term, the market is very volat ile, so don't fret when the market drops 10 percent in a week, or your account seems to be worth a lot less than it was last month. Over five, ten, or 20 years, you'll come out much further ahead by sticking with stock funds. Think big. When you invest in the big American companies, companies like Microsoft, Intel, AT&T, and General Electric, you don't have to worry much about whether they will be going out of business any time soon. What's more, these industry leade rs have generated outsized returns for their shareholders over the past decades. Bigger isn't always better, of course, but "large-cap" stocks like these provide plenty of solid returns (over the long-term, of course). Invest in these stocks by buying a l arge cap stock fund. Think international. The world is a big place and getting smaller as we build telephone lines and Internet connections and satellites that send signals all around the world. Still, somehow, the stock markets in other countries always tend to go down when the U.S. market is up, and vice versa. You can take advantage of this trend by including some global stocks in your portfolio along with big American stocks. You can do this by buying a fund specializing in large international stocks. Think small, too. Every big company once started out as a small company. If you can buy good companies when they're small, you'll benefit as they get to be big and successful companies. Trouble is, lots of small companies just get smaller and ev entually go out of business. So small company stocks tend to be a little riskier than big stocks. But here's the good part -- another funny thing about small stocks is that they tend to do well when big stocks are doing lousy, and vice versa. So if you ow n big and little companies in you portfolio, over the long-term, things will more than balance out in your favor. Do this by buying a small cap stock fund. Put it all together. Large cap stock fund. Small cap stock fund. Large cap international fund. Divide your portfolio into three and put a third in each. Now you've got a diversified portfolio in which at least one sector will be doing okay (or b etter than okay) nearly all of the time. Consider index funds. The Standard & Poor's 500 is one of the best known stock market indexes, made up of 500 big American companies from all industries. An S&P 500 index fund simply invests in the 500 stocks in that fund -the fund's advisors don't try to pick stocks that will beat the market. Index funds always match the performance of the market (or of the sector that the index tracks), so you don't ever have to worry about your index fund dogging the market. As a bonus, these funds have low expenses (the fees that the fund's managers take off the top) and that increases your returns. Avoid overlap. Sometimes people think that if one large cap fund is good, two or three are better. When you buy several funds of one type, more likely than not you'll just end up owning roughly the same set of stocks. Not only will you probably not increase your overall returns, you'll create more work for yourself by having to track additional funds. Choose one good fund of each type in your portfolio and, as long as they continue to perform well, stick with them.

Consider asset allocation funds. Don't want to be bothered with choosing one fund of each type? Asset allocation funds are "funds of funds," or mutual funds that themselves own several funds of different types. Bear in mind that you'll pay for t his convenience, however. These funds generally carry higher expenses and, more often than not, loads. Avoid bond funds. If you have five years until you will withdraw your investment (like for retirement), then bonds might be appropriate for perhaps 10 to 20 percent of your portfolio, and increasing to perhaps 40 percent (at most) when you are a t retirement age. The problem that most people have is that they think bonds are "safe" -- but bond returns are still volatile, and will give you a lower rate of return than stocks over time.

Spiders:
S&P Depositary Receipts are usually shortened to SPDRs, and pronounced "spiders." The SPDR Trust is a unit investment trust based on the Standard & Poor's 500 Index, and it owns a fixed portfolio of all the stocks that make up the S&P 500. Each SPDR represents a single unit of ownership in the S&P 500, and can be bought and sold, much like a stock, on the American Stock Exchange. For investors who are looking to match the performance of the overall market, as represented by the S&P 500, SPDRs may be a smart option to consider. SPDRs were first created back in January 1993 by a subsidiary of the American Stock Exchange. They trade on the Amex, and you can find them listed in quote servers under the symbol SPY. However, it's easy to figure out the price of a unit in the trust -- it's always the current value of the S&P 500 Index divided by 10. If the S&P 500 Index stands at 1097.31, the unit price of a SPDR is $109.73. You can buy shares in SPDRs at any time when the market is open. (In comparison, you can only buy mutual fund shares at the end of the trading day.) Any brokerage firm will happily assist you in purchasing SPDRs for your portfolio. (For a commission, of course). SPDR holders receive quarterly "dividend equivalent amounts" of cash for each SPDR unit they own, based on the dividends paid by the stocks in the S&P 500. The dividends are paid to SPDR holders quarterly on the last business day in April, July, October and January. State Street Bank & Trust of Boston holds the actual shares of stock that make up the SPDR Trust and deducts a small management fee from the dividend distributions paid to shareholders. SPDR Trust expenses are currently at 18.45 basis points (in English, that's 0.185 percent). One way that SPDRs are different from an S&P 500 index fund is that SPDRs, like all unit investment trusts, expire after a certain length of time. What is particularly unusual about SPDRs is their expiration date, December 31, 2099 -- the end of the 21st century -- perfect for really long-term investors. Two last incidental notes: SPDRs can be sold short in the market, so some investors use SPDRs as a vehicle to bet that the overall market is headed for a decline. And MidCap SPDRs are also available to track the value of the S&P MidCap 400 Index, a benchmark for middle capitalization companies.

Cost Control:
The corrosive effect of fees and taxes is the single biggest disadvantage of investing in mutual funds. Our view is that the entire fund industry suffers from a serious cost-control problem that contributes to the subpar returns posted by too many funds. If you aren't careful, management expenses and capital gains taxes can shave hundreds -- if not thousands -- of dollars from your returns over the years. The good news is that it's still possible to find excellent funds with relatively low costs. You just have to know what to look for. This section discusses the various charges you'll face when shopping for mutual funds, with guidelines as to acceptable fee levels. We'll also explain what to look out for in terms of taxes (though this is covered in more depth in our Taxes and Investing course). One point we would make from the top, however, is that index funds are by nature the lowest-cost funds because of their lack of active management. As you'll see, they're also the most tax efficient. If your goal is to get into the market as cheaply and simply as possible, index funds are probably the way to go. Loads: Front- and Back-End Mutual fund people talk a lot about load funds and no-load funds. A "load" is simply a sales charge tacked onto the price of a mutual fund to compensate the broker or financial adviser who sells it to you. Loads work in two ways. You pay them either upon buying your shares or selling them, depending on the fund.

A "front-end load" is charged when you buy your shares. It typically ranges between 2% and 6% of your initial investment, and some funds charge you again for reinvesting your dividends in new shares of the fund. A "back-end load" is a fee the fund charges when you sell -- or redeem -- your shares. These deferred fees are essentially a tactic to keep you invested in the fund for the long term. A typical scenario would work this way: In the first year of ownership, you'd pay a charge in the range of 4% to 5.75% if you sold out of the fund. After that, the percentage declines each year until it disappears altogether after about six years. The obvious problem with a load is that it immediately trims your investment return. That might be acceptable if you believe the fund will post such superior returns that the load will pay for itself over time. But since there are plenty of quality no-load funds out there, why pay a fee you don't have to? We never say never when it comes to paying fees, but at SmartMoney, we tend to recommend no-load funds exclusively. Expense Ratios Even a no-load fund hits up its shareholders for the costs of doing business. These include everything from the advisory fee paid the fund manager to administrative costs like printing and postage. These costs are expressed as an "expense ratio," which is an annual percentage of the fund's average net assets under management. Published fund returns are usually calculated net of annual expenses, but you should definitely pay attention to them. When you get your statement at the end of the year, you can count on the costs being skimmed off the top. There's a temptation to associate high expenses with good fund management. Some people figure it's like anything else: You get what you pay for. The fact is, however, that low-expense funds are more likely to outperform highexpense funds over the long haul. Recently, the average expense ratio for domestic equity funds was about 1.4%. For fixed-income funds it was about 1.1%. International funds have higher expense ratios, averaging around 1.9%. There is no reason to buy funds with expense ratios higher than that. 12b-1 Fees These are fees the fund charges for marketing and distribution expenses. They are included in the expense ratio, but often are talked about separately. These fees are charged in addition to a front- or back-end load, and you'll find that many no-load funds charge them, too. If a 12b-1 fee puts a fund's expense ratio above the average for that class of fund, think twice before buying. Taxes Our Taxes and Investing section covers this issue in much more depth, but when it comes to mutual funds and taxes, the basic issue is this: When a fund manager sells a stock for a gain, the law says it becomes a taxable event. That transaction may be offset by any losses the manager incurs when he sells a doggy stock. But if the sum of all the transactions during the year adds up to an overall gain, somebody has to pay the tax bill. We'll give you three guesses who that ends up being. These gains are paid out in the form of taxable distributions. There's nothing worse than ending the year with a fat one you weren't expecting. It's even more bitter when the gain falls into the short-term category -- a big problem with fund managers who trade often. Short-term gains are taxed as regular income instead of at the lower, 20% tax levied on long-term capital gains. In 1998, some funds had distributions as high as 28% of their total assets. Shareholders paid taxes of anywhere from 20% to 39.6% of that. The only way to avoid the problem is to look for fund managers who don't typically trade a lot. In 1997, for instance, Phoenix Aggressive Growth had a turnover ratio of 518%, meaning that during the year, the fund manager sold 518% of the stocks in his portfolio. Shareholders got slapped with a 20% distribution, most of it short-term gains. By contrast, the Torray Fund had just 12% turnover and its distribution was only 1.7% of net asset value. When it comes to tax efficiency, you can't beat index funds. By charter they don't trade much; they buy the stocks in an index and hold onto them for the long haul, rebalancing them only when they have to. If you want an actively managed fund, however, make sure you pay attention to churn rate.

Tax Efficient Investment:
Many typical portfolios have more than 40 percent of their returns taxed away. Millions of investors are giving too much of their tax dollars back to Uncle Sam due to inefficient investing. Even though you cannot escape taxation altogether, you can cut this burden with a few simple strategies. Tax-efficient investing does not apply to your individual retirement account and retirement money. It is most relevant if you are in a middle or upper tax bracket of at least 28 percent.

Most of the investment management industry has all but ignored the effects of taxes on your portfolio. Investment management has keyed on nontaxable accounts, such as pension accounts, ignoring individual investors' taxable portfolios. The mutual fund industry has also continued, for the most part, to ignore taxes and pretend that every customer is in an IRA or 401(k) account. Generally, brokers tend to ignore taxes. The way brokers make money is in buying and selling stocks that trigger capital gains, or selling load funds, which trigger yearly gains. Holding a good-quality common stock is one of the best tax shelters left. Only bank trust departments and money management firms that cater to the higher tax payers have historically stressed tax-efficient investing through individual stock and municipal-bond management. Some breakthroughs have occurred with tax-efficient mutual funds, however. Morningstar, the leading independent reviewer of mutual funds, has started to compute a "tax efficiency ratio." This ratio represents the percentage of the fund's pretax return that an investor was able to keep after taxes. Funds rate from 60 percent to 100 percent, which is a tremendous difference in after-tax returns. Index funds typically have low turnover and high "tax efficiency." If you have less than $200,000 in your taxable portfolio, looking for tax-efficient equity funds, such as an index fund, and a municipal bond fund is a good strategy. If you have built up a substantial taxable portfolio, it would pay to seek professional, tax-efficient investment management from your local bank trust department or money management firm. These firms will work with your CPA and estate attorney to maximize your after-tax return. Unlike many no-load mutual funds, which distribute capital gains yearly, trust departments and money managers will manage individual stocks, creating taxable gains and income when it makes sense for you. They also have expertise in individual municipal bonds and buy them at low commissions. These managers get paid on a percentage of your assets after taxes, so they share in your interest to build the portfolio and to maximize your after-tax return. Taxes are relevant and certain. Last year's hot mutual fund could be this year's dog. People should spend more time looking at tax effects they can control and less time on betting on the next hot investment. Making a portfolio more tax efficient is an easy way to immediately increase after-tax returns.


				
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