Q. I bought 300 shares of the Vanguard Total Market Index Fund in November of 2002. I purchase $500 worth of this fund each month. In your October 15 column, you discussed the negative capital gains exposure for this and other index funds. However, I am confused about the implications of negative capital gains.

Can you say more about what the negative capital gains exposure for this fund means for me?

---M.W., by e-mail

  

A. Certainly. In short, it's very good for you. What happens with unrealized capital gains (or losses) is probably one of the most difficult things about mutual funds to understand. When we buy shares in a mutual fund we buy shares in an underlying portfolio containing a variety of investments purchased at different times.

Some of those investments will have been bought at lower prices, some at higher prices. Altogether, the cost basis for the entire portfolio may be a good deal lower, or higher, than what we pay for the shares. What we pay reflects the value of the shares in the portfolio only on the day we buy the shares.

Now consider two examples. Suppose you bought shares in a fund for $10 but the cost basis of the shares in the underlying fund was actually $8. In that case, 20 percent of your investment would be unrealized capital gains. If the portfolio manager decided to sell all those stocks and build a new portfolio he would realize all those capital gains and you would get a $2 capital gain distribution.

That distribution would be taxable income to you. Financial planners call this "buying a tax liability." Your investment might still be worth the same amount, in total, but you would have to pay taxes even though you didn't have a real gain. This is how it is, most of the time, in mutual funds--- you're buying some amount of tax liability because the underlying portfolio has unrealized capital gains.

Today, most equity funds are in the opposite position. You can buy shares in the fund for $10 but the underlying portfolio contains stocks that may have been bought for $12 a share. The fund may have unrealized or undistributed (but realized) capital losses. When this happens, you aren't "buying a tax liability." In effect, you are buying a tax subsidy. Losses that already exist will prevent the fund from distributing capital gains until the gains outweigh the losses.

At the end of January, Vanguard Total Stock Market fund had capital losses equal to 25 percent of fund assets. This means the portfolio can increase substantially in the future without distributing any capital gains.

Now here's the hard part. What a fund distributes in capital gains is quite separate from sales that you do as a shareholder. If you purchased shares at $10 and sold them at $12.50 you would realize a capital gain of $2.50 a share. The capital gains and losses in the underlying portfolio ONLY have an impact on taxable distributions by the fund.

  

Q. Some time ago I read an article about a mutual fund designed for children. It focused on companies involved in products that children would most likely know about. Could you give me the name of this fund and, also, your opinion about it? Their grandfather wanted to start giving the three grandchildren $10,000 per year to build up a fund for their college education and I am thinking this would be a good way to do it.

---E.B., by e-mail

  

A. The fund you have in mind was called Stein Roe Young Investor Fund until last July when it became the Liberty Young Investor Fund. While the "Z" shares of the Liberty version of this fund have a low expense ratio--- only 0.58 percent according to fund data source Morningstar--- it has trailed the S&P 500 Index by just over 3 percentage points a year for the last 5 years and trailed 62 percent of its large growth fund competitors.

As a consequence, the fund has more charm as an idea than as an investment. You could, of course, buy some shares with the idea that it would be a useful teaching instrument--- and then supplement with shares of major index funds