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Foolbdweese wrote:

I imagined an index fund to be pretty bland with computers doing all the heavy lifting, however the prospectus for the subject fund mentions "In addition, to provide liquidity and for hedging purposes, a small portion of the funds assets will be invested in high quality money market instruments and financial futures contracts."

The money is invested in money market instruments to provide liquidity so that the fund will not have to sell securities to cover redemptions. This should be a low figure in terms of assets. I would think no more than 5% of the fund's assets should be held in cash for this purpose. The better index funds will actually be lower than this. As far as hedging purposes, the prospectus states this so it will be allowed. Whether this is actually being done is a different matter. As an index fund it should not come into play. An actively managed fund will utilize this provision if the manager feels that the market will enter a down turn. The fund manager will hedge or protect the fund against this by removing assets from the market and investing in cash. Index funds should have no human involvement, and aside from the cash set aside for withdrawals, should be fully invested.

Foolbdweese wrote:
"From time to time, to increase its income, the fund may lend securities from its portfolio to brokers, dealers, and other financial institutions needing to borrow securities to complete certain transactions. Further, assets of the fund may be invested in other
collective investment funds that engage in securities lending. To the extent the fund engages in securities lending, either directly or through another collective investment fund, the fund may be subject to securities lending fees and certain risks associated with securities lending."

This is a very common practice among all mutual funds and does in fact increase the income the fund generates in return for very little additional risk.
What is happening here is the fund is buying stocks that make up its portfolio and then lending those stocks to other broker/dealers who may have shorted the stock or want the stock for other reasons. This is done through Securites Lending and can be done through straight lending in exchange for collateral and a fee or by doing what is known as a Repurchase Transaction or REPO. The fund will lend lets say 1,000 shares of IBM to Broker A. The fund remains owner of the shares and can ask for them back at any time. In return Broker A provides collateral equal or exceeding 102% of the market value of the 1,000 shares, usually in the form of gov't securities. If the market value of IBM goes up, Broker A will provide additional collateral. When the loan term is up, Broker A returns the shares, and the fund returns the collateral. For use of the stock during the term of the loan, Broker A will pay the fund a fee. This fee varies depending on the demand for the shares, the term of the loan and the quality of colateral involved. If your fund wants to increase its income it will accept lower grade collateral.
Putnam funds tend to be on the high end of the expense scale in terms of fees. However, I would not be very alarmed by the statements in the prospectus. Sorry this was such a long post. Hope it helped. If not, please follow up with additional questions.

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