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How You Can Profit From a Mutual Fund

You make money from your mutual fund investment when:

1.The fund earns income on its investments, and distributes it to you in the form of dividends.
2.The fund produces capital gains by selling securities at a profit, and distributes those gains to you.
3.You sell your shares of the fund at a higher price than you paid for them.

How you are most likely to profit from your fund investment depends on what kinds of assets your fund holds. The major asset classes differ in their tendency to produce income dividends, capital gains, share price appreciation, or a combination of the three.

Dividend Distributions Capital Gain Distributions Share Price Appreciation
Cash Investment
Yes
No
No
Bonds
Yes
Some
Some
Stocks
Some
Yes
Yes


Here's what this means for the four categories of funds.

Money Market Funds:
Invest in money market instruments (also known as "cash investments"), which are short-term securities (that mature in 13 months or less). (Money market funds are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.) Produce profits that consist entirely of dividend distributions.
Do not produce capital gains or share price appreciation, because they seek to maintain a stable $1 net asset value. (Although money market funds seek to preserve the value of your investment, it is possible to lose money by investing in these funds.)

Bond Funds:
Invest in bonds, which are debt securities, or IOUs, issued by corporations or governments in exchange for money loaned to them. Generally, the issuer agrees to repay the loan by a specific date and to make regular interest payments to the lender until then. Produce profits that consist primarily of dividend distributions. May generate modest capital gains. Fluctuate in value, so it is possible to sell shares at a higher price than you paid for them.

Stock Funds:
Invest primarily in common stocks, which represent part-ownership in corporations. May pay you modest dividends from income generated by the corporations in which they invest, and from short-term cash investments. Stock funds that follow a "value" investing style generally produce more income dividends than "growth" stock funds. Produce profits that consist primarily of capital gains. Stock funds that follow a "growth" investing style generally produce more capital gains than "value" stock funds. Fluctuate in value, so it is possible to sell shares at a higher price than you paid for them.

Balanced Funds:
Invest in stocks, bonds, and cash investments, in varying proportions. Produce dividend and capital gains distributions and share price appreciation in proportion to their allocation among the three major asset classes.


Defining Mutual Fund Costs

All mutual funds have costs, but some are more expensive to own than others. And even seemingly minor cost differences can significantly affect the growth of your investment assets.

Mutual fund costs fall into two main categories: sales charges (known as "loads") and operating expenses. Not all funds impose loads, but all do have operating costs that are deducted from fund earnings. You may also encounter other fees.

Loads

Loads come in three forms:

Front-End Load

1.Charged when you purchase fund shares (effectively reducing your purchase amount).
2.May be charged on reinvested distributions.
3.Ranges from 3% to 8.5%, according to Lipper Inc.

Back-End Load
1.Charged when you sell fund shares.
2.Usually assessed based on the length of time you have held your shares, and declines over time.
3.Can be as high as 6% if you sell shares within one year, according to Lipper Inc.

Level Load
1.Deducted annually from fund assets as marketing and distribution costs.
2.Used to pay commissions to brokers and the fund's financial adviser, and is generally reported as part of a fund's operating expenses.
3.Can be as high as 0.75% per year, according to Lipper Inc.
4.Funds that have no sales charges are known as "no-load," while funds that charge loads of 1% to 3% are called "low-load."

Operating Expenses

Basic operating expenses include investment advisory fees, legal and accounting services, printing, telephone service, postage, and other administrative costs.

Operating expenses:

Are deducted from a fund's earnings.
Are called an "expense ratio" and are usually expressed as a percentage of a fund's average net assets.
Typically range from under 0.20% (or $2 per $1,000 invested) to more than 2% (or $20 per $1,000 invested) of fund assets, according to Lipper Inc. May include a "12b-1 fee," which charges marketing and distribution expenses directly against fund assets. (The term "12b-1" refers to the section of the 1980 Securities and Exchange Commission rule that permits this practice.) Such fees usually range from 0.25% to 1% of the fund's average net assets, according to Lipper Inc. (A fund that charges no load or 12b-1 fee is known as "pure no-load.")

Note: New funds sometimes temporarily waive their investment advisory fees or absorb operating expenses to enhance total return. Be alert to this marketing ploy when comparing the returns of two funds; an artificially depressed expense ratio will probably rise later.

Other Fees

Funds may charge many types of fees. The following are the most common.

Type of Fee When Changed Fee Amount
Exchange fee When you sell fund shares and use the proceeds to buy shares of another fund in the same fund family Typically $5 to $25
Account maintenace fee Frequency varies, but typically on a quarterly or annual basis to help offset the costs of maintaining small accounts Typically $10 to $25
Transaction fee When you buy or sell funds shares Typically 1% or 2%. Paid directly to the fund to help defray the costs of buying and selling securities


Keep in mind that:
Mutual funds are legally required to disclose all fees and expenses in a standardized table at the front of the prospectus. This assures your ability to compare fund costs. You don't necessarily "get what you pay for" when it comes to mutual fund costs. According to William Sharpe, the Nobel Prize-winning economist, "There is virtually no evidence to suggest that funds with higher expense ratios do better, before expenses. Which therefore suggests they will do worse, after expenses." While costs matter, you should not base investment decisions on cost alone. Of primary importance are your investment goal, time horizon, risk tolerance, and financial resources.


Continue to part 2


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