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 Fidelity's 140. At the time of publication, there were 338 fund groups, offering more than four thousand funds. That may seem like an overwhelming choice, but it's nothing compared with the numbers you'd face if you were choosing an individual stock.

Different funds are created to appeal to a variety of investors, both individuals and institutions, each of whom may have different objectives and approaches to investing.

In each case, the fund company follows these steps in creating a fund:

It decides on an investment concept, or objective, for its fund.
It prepares and issues a prospectus that explains the fund's goals and operation.
Finally, it sells shares to the public.

Mutual Fund Objectives

A fund's objective, or investment goal, usually revolves around one basic tradeoff. A fund will generally favor one of two approaches:

Providing its investors with a regular income

Maximizing the potential for future growth in value
Most funds offer a balance of these two objectives, in different proportions. Investors will consider this balance very strongly before investing in a fund.

Each mutual fund must have an investment objective or goal, and a plan - sometimes called an investment program - it follows in building its portfolio. For instance, a fund that seeks growth buys shares in companies that it expects to expand and prosper in the years ahead.

Any major changes in the way a fund operates or invests its money must be approved by its shareholders.

Open-End Funds

Most mutual funds are known as "open-end" funds. That means the fund sells as many shares as investors want. As money comes in, and the number of shares increases, the fund makes additional investments.

So the more money investors put into an open-end fund, the larger it grows.

Sometimes a mutual fund company will close an open-end fund to new investors if it grows too large to be managed effectively; even then, current shareholders can continue to invest money. When a fund is closed this way, the investment company often creates a new fund with a similar portfolio to allow new investors to buy in.

Closed-End Funds

"Closed-end" funds are hybrids, with some similarities to open-end funds and some similarities to stocks.

Closed-end funds invest in a portfolio of securities, the same way open-end funds do, but a fund raises money only once (like the initial sale of a stock) and offers investors only a fixed number of shares. After the initial offering, shares in the fund are traded on a stock exchange. Sometimes, they're also referred to as "exchange-traded funds."

The price an investor pays for a closed-end fund fluctuates in response to investor demand as well as to changes in the value of its holdings.

Managing a Fund

For many people, the appeal of mutual funds is that someone else makes the investment decisions.

A fund's buy and sell decisions are made by a professional manager who specializes in the type of investment the fund makes. In fact, the identity of the manager is often a key factor in how well a fund does--and a manager's departure may be a signal to investors that it's time to get out of the fund.

Marketing a Fund

Fund companies package and promote their funds to attract new customers and keep old ones. Especially in the last few years, some mutual fund companies have launched slick marketing campaigns to promote their product aggressively to younger investors. You may have seen some of these ads on places like cable television: it can be hard to tell the mutual fund ads from the music videos.

But don't expect the Beastie Boys to be endorsing mutual funds any time soon. Traditionally, mutual fund companies advertise their wares through the financial press, direct mailing, and press announcements. In some cases, they work with brokers who make commissions selling particular funds. Conscience or green funds, for example, are created to attract investors whose political views would favor environmentally friendly investments.

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 pays out, or distributes, 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.

Mutual funds that pay regular distributions are known as income funds.
Funds that increase in value but don't pay much in distributions are known as growth funds.

Taxes on Distributions

Uncle Sam wants his share of any earnings you have on your mutual funds.

You owe federal and sometimes state income taxes on the distributions you receive from a taxable fund, whether the money is reinvested or paid out in cash.

But if a fund loses more than it makes in any year, the losses can offset future gains. Until profits equal the accumulated losses, distributions aren't taxable, although the share price may increase to reflect the profits.

Reinvesting your Distributions

Sure, mutual funds have been known to deliver some pretty impressive returns. But that's not the only reason mutual fund investments seem to grow larger, and faster, than some other investments.

It's also because mutual funds offer the option of reinvesting all or part of your distributions to buy more shares in the fund. Then you've got a bigger investment base, which can earn bigger distributions, and so on, ever upward.

Many financial experts recommend using mutual funds as long-term investments, funneling all your earnings back into the fund.

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