Dash off a check, pop it in the mail, and suddenly you own shares in a mutual fund. It's a routine act of faith. Some 22 million American households these days entrust their money to the money managers at mutual funds.
But it's not exactly the same thing as going to the bank. When you put your money in a savings account or certificate of deposit, you know you're getting a nice, safe return -- plus federal deposit insurance, and, well, that feeling of solidity and conservatism that has always made banks and savings-and-loans seem permanent and safe.
But what exactly are you putting your faith in when you send your money to a mutual fund?
The short answer is: a business with investment expertise, financial clout, a carefully cultivated reputation -- but also with few guarantees. Thus it behooves you to know as much as possible about the reputation of the mutual fund you invest with.
Let's follow your money through a mutual fund to see just what happens.
Your part in the transaction is relatively simple. You read a newspaper ad, write or call for information, and receive a prospectus. Examine it. The information is unique to your fund and is very, very important for you to understand before you proceed.
You should see if you like the fund's historical rate of return, management style, and investment goals. You should also figure out whether you are eager to pay the fund's sales ``load'' or whether you'd rather go the ``no load'' route with another fund. The prospectus gives these details.
You also decide on such options as dividend reinvestment, capital-gains distributions, systematic withdrawals, telephone-switch provisions, and so on. If you qualify for a 401k or 403b plan at work, you may arrange for payroll deductions -- at least as long as the government allows deductions.
Then you place your order: mailing in your application along with the initial investment, typically beginning around $250. This is done by a stockbroker or financial planner if he or she originally sold you on the idea of a mutual fund -- especially if the person gets a commission on the sale.
The order to buy shares of a mutual fund is sent to a ``transfer agent'' -- a kind of notary who keeps a record of each shareowner's name, address, and number of shares and sends confirmation of investment activity to you. The money then goes to the ``custodian'' -- the bank that safe-keeps the mutual fund's assets. The transfer agent and the custodian may be affiliated with the mutual fund company or with each other.
The custodian then informs the mutual fund that your bucks are in the fund's account, and the mutual fund's professional investors, known as the ``management company,'' take over.
This, of course, is the important part. All that led up to this point was routine. But here is where the mutual fund earns its management fee (usually one half of 1 percent of total assets) each year. It is where you get what you wanted when you signed up: return on your investment.
If the investments do well, the mutual fund's profit soars along with yours, and its reputation waxes. The words ``Fidelity Magellan,'' for instance, are synonymous today with extraordinary quality and growth. Ten years ago, it was just a young mutual fund like many others.
How and where the money is invested is the key to a mutual fund.
Your money and that of thousands of other investors is pooled. It can buy enormous blocks of stock at a time. These big blocks mean lower transaction fees for the mutual fund than you would have as an individual investor.
And the economy of scale that a mutual fund provides means it can utilize elaborate stock-market technical research and sophisticated trading maneuvers that an individual investor can scarcely marshal himself.
At every mutual fund there is some sort of investment policy committee. It is usually composed of managers of individual funds within the company, economists, market specialists, and the chiefs of the mutual fund company.
The committee tries to figure out where financial markets are heading and sets the overall level of exposure for stocks, bonds, and cash or cash equivalents.
This is the decision that fund managers call ``asset allocation.'' Albert Elfner at Keystone Massachusetts, a Boston-based mutual fund family, says that ``two-thirds of all performance is related to the process of asset allocation; therefore, there's a considerable effort there.''
At this point at most funds, researchers analyze various sectors of the economy and then industries within those sectors that will do best in the overall economic environment their bosses have postulated.
And finally, mostly using ``fundamental analysis'' of individual corporations, researchers and portfolio managers try to determine what specific stocks should be bought, sold, or avoided.
Mr. Elfner says his fund managers look for stocks with ``positive earnings momentum at a reasonable price.'' He adds, however, that ``stock picking is the small end of the telescope.''
The portfolio manager then contacts the equity traders and they execute the purchase, sale, or any number of complex risk-hedging maneuvers using stock futures, options, and indexes.
The trading desk is tied in with several dozen of the biggest brokerages on Wall Street and with the NASDAQ electronic trading system. Deals can be done worldwide and in huge volumes.
Trading is complex because of the size of the blocks that the mutual fund puts on the market. A big sale, for instance, can cause the market price of a stock to fall significantly before the transaction is completed, and that can cost the firm money. Elfner says that ``avoiding a wave'' is a key consideration for his traders.
``The cost and `wave effect' is importantly determined by the liquidity of a stock,'' he says. ``With AT&T there's probably not much of a wave. But with Crazy Eddy it may take a week or two to complete an order.''
All of this is supposed to make money on your money. The money that the fund's investors make for you is distributed -- after paying the management company's expenses -- as dividends, which, in many instances, are then reinvested to buy more shares.
The truth is, in a rising stock market, most mutual funds do well. In a falling market, most do poorly.
Still, according to a New York Stock Exchange study, mutual funds are the key way most Americans participate in the stock market.
The Investment Company Institute, the mutual fund trade association, is preparing an 80-page booklet of basic questions and information about mutual funds. Ask for ``The Investment Company Institute's Guide to Mutual Funds,'' 1600 M Street NW, Washington, D.C. 20036. It costs $1.