(FORTUNE Magazine) – It used to be so simple. You bought a mutual fund, and the mutual fund bought stocks and bonds. No more. In the Seventies, as baby-boomers were savoring the joys of free love, fund managers started messing around with puts and calls. The Eighties brought a proliferation of futures and stock-index options. Now some mutual funds, along with banks and corporations, are snapping up financial esoterica as fast as Wall Street can pump them out: swaps and structured notes, caps and floors, IOs and POs. Horror stories abound of huge losses from these volatile and complex instruments. As a mutual fund owner, should you worry? Probably not. In the right hands, these so-called derivatives can lower the risk of a fund and juice up its return as well. ''They're just like chainsaws,'' says Charles Taylor, executive director of the Group of Thirty, a policy research group that recently published an influential study of the subject. ''If you read the instructions, they're very useful, but you shouldn't let minors use them, and you should be careful using them yourself.'' So what are they, anyway? Derivatives, loosely, are investments that ''derive'' their value from changes in one or more underlying indicators. A call option on General Electric, for example, moves up if the stock rises (see glossary). Some derivatives, such as options and futures, are standardized and trade on exchanges. Others, like swaps and structured notes, are custom-made by large dealers in agreements with corporations and institutional investors. The latest tales of woe come not from any inherent flaw in the instruments but from a misjudgment by investors. As interest rates started diving last year, homeowners refinanced their mortgages at a faster-than-expected clip -- and owners of IOs, ''interest-only strips'' that give the investor only the interest portion of a mortgage payment, saw their investment plunge. Once the principal is repaid, the interest stream dries up. Auditors recently discovered that Ohio's counties, cities, and schools had lost millions on IOs they bought in 1991 and 1992; now the state has banned that kind of investment. Owners of Hyperion 1999 Term Trust, a closed-end fund that had an estimated 30% of its assets in IOs, sued the investment company in October after the shares dropped 30% and the dividend was cut from 80 cents to 52 cents. Blame the money managers for a bad call, if you like, but don't scratch IOs as an investment device. As one student of derivatives put it: ''IBM stock owners lost a lot of money too. Does that mean you should outlaw trading in IBM?'' Randall Merk, a manager of mortgage funds at Benham Capital Management, employs both IOs and their opposites -- principal-only strips, or POs, which rallied as prepayments picked up. ''They're like seasoning in a stew,'' he says. ''If they're judiciously put together, they can improve the total return of the fund and reduce the volatility of the share price.'' About 3% of the $1.2 billion Benham Adjustable Rate Government Securities fund is invested in these derivatives. Many derivatives are used solely to reduce risk and don't pack nearly the punch of IOs and POs. Take currency forwards. As money gets ever more global, many funds use them to protect the yield and capital appreciation of foreign stocks and bonds from a sudden rise in the price of the dollar. Pacific Investment Management Co., for example, always hedges at least 75% of the foreign bonds in its mutual funds; that kept investors in Pimco Total Return and Pimco Foreign safe during Europe's recent currency storms. Derivatives can be used to hedge equities as well. Richard Howard, portfolio manager of the T. Rowe Price Capital Appreciation fund, recently bought puts on 20,000 of his 70,000 shares of Litton Industries. If the stock rises, the puts are worthless -- and that's just what Howard hopes will happen. But if it falls, the puts rise in value, protecting part of the investment. ''It's a way of dampening your risk,'' he says. In fact, most funds use derivatives more for risk management than for speculation. At least part of that conservatism stems from regulation. For example, Gus Sauter, who runs the Vanguard Index Trust-500 Portfolio, can control $230,000 worth of S&P 500 stocks by putting up only $9,000. That 25- to-1 leverage means that in a year when the S&P 500 returns 10%, futures ) could hypothetically give investors a gain of over 250%. It also means, however, that if the S&P plunged to zero, Vanguard would owe the issuers of those futures contracts more than the assets of the fund. To keep the SEC happy and his investors sheltered, Sauter must have enough cash on hand to cover the amount that such instruments control ($230,000 per contract, in the example above). Sauter uses the futures market because he can often profit from temporary mispricings of the contracts. It also allows him to earn a market return while maintaining cash on hand for investors who redeem their shares. Derivatives open up a land where aggressive managers can place financial bets they couldn't otherwise make. Art Steinmetz, manager of the Oppenheimer Strategic Income fund, thinks French short-term interest rates will come down faster and further than long rates. But short bonds don't bounce upward in price as much as long bonds do when rates fall. To get a long-bond kick from a short-bond rate drop, he is thinking of buying a ''structured note'' in which the value of the principal is linked to the interest rate on two-year French bonds. The deal would provide that any price movement in the short bond is then multiplied seven times. That septupling would give Steinmetz the volatility of a 30-year bond based on the movement of the two-year rates. When managers like Steinmetz buy such a custom-made derivative, they know precisely the risk they're taking. The same can't be said of investors who buy into funds that use such products. The suit by the hapless Hyperion owners alleges that the prospectus failed to disclose the true risk of IOs; Hyperion denies it. The moral? Know your fund -- which may get easier. Right now, while many funds have added clauses to their charters allowing broad use of derivatives, they need not specify which instruments they are using at a given moment. Commissioner J. Carter Beese says the SEC will push for disclosure that ''moves beyond the boilerplate variety we have today.'' Private monitoring firms are helping out. Fitch Investors Service now rates bond funds on volatility. The write-ups describe funds' holdings, including such temperamental instruments as IOs. Morningstar also plans to report on the derivative holdings of mutual funds. Why, derivatives will soon be as simple as free love used to be.

BOX: A DERIVATIVES GLOSSARY

-- OPTIONS: A ''call'' option allows you to buy a security at a set time for a $ set price; a a ''put'' option gives you a similar right to sell a security.

-- FORWARD CONTRACTS: A contract obliging two parties to trade a security or currency at a specified price and date.

-- FUTURES: Like forward contracts, but traded on an exchange. Futures are typically settled in cash, rather than requiring delivery of a security or currency. Best known: S&P 500 futures.

-- SWAPS: Most common are interest rate swaps, where two parties exchange interest rate payments on a common principal: floating for fixed rate, or one currency for another. If a manager who owned a floating-rate note were convinced interest rates were going to fall, he might want to enter into a swap in order to get fixed-rate payments instead. Equity swaps are growing in popularity.

-- STRUCTURED NOTES: Corporate or government debt instruments created by dealers in which the interest rate or principal is pegged to an unrelated indicator: the price of oil, the Nikkei index, etc.