“Mutual fund” is an investment vehicle that is almost 200 years old. This type of investment has become extremely popular, especially in recent decades. Back in the 60s, there were only 30 mutual funds in Canada with a total managed capital of 560 million dollars. But according to the latest statistics of the year 2018, it is estimated that the total capital in mutual funds presented in Canada exceed 1400 billion dollars. Mutual funds collect funds from a large number of investors and choose to invest in variety of securities (stocks, bonds, real estate development companies, etc.) at their own discretion. Each investor gets a share of the profits or losses of this investment, proportionate to his/her share in the fund. Mutual funds are run by professional individuals in the field of investment and thus are suitable for people who do not have enough time or expertise to manage their own money. The advantage of mutual funds for ordinary investors is that they do not need to know the details of the investment. In fact, fund managers are in charge of all the investment affairs, selecting type and percentage of the securities and the time to purchase and sell them. The investor only buys the stock/unit of the fund and receives profits/losses proportionately. To summarize, in a mutual fund, a collection of investors give their money to a set of experts to make investments for them.
Currently, more than 4000 different mutual funds operate in Canada through more than 140 companies. Mutual funds are not all the same and they vary according to their risk levels and potential for capital growth. Regardless of type, quantity and quality, mutual funds have certain advantages and disadvantages as an investment product.
Advantages of Mutual Funds
Low-cost but Professional Capital Management: You will surely face some challenges if you want to enter the investment market directly on your own. Knowledge, experience, and time might be the most important challenges you will face. In addition to that, knowing when to enter the capital market and when to exit it is a difficult and complicated task. Successful investment and entering the capital market is a specialized task and requires professional skills. You need to pay a considerable amount of money if you want an expert to handle your capital. For example, imagine in a country where a McDonald’s employee earns 2000$ a month, how much will an expert in the field of finance charge you to make investment decisions for you? If you do not have a significant amount of money, it is possible that the expert will not accept your money and even if he does, the price you need to pay will certainly be more than your capital appreciation and it will not be worth it. Mutual funds solve this problem. By collecting money from a large number of investors (sometimes reaching more than billions of dollars), mutual funds make it possible for people with only 1000$ to use this professional capital management service only by paying a small percentage.
Investment Diversification and Risk Reduction: Diversification in investment is of paramount importance for risk reduction in modern investment. Mutual funds generally invest in securities, bank deposits, stocks, and corporate bonds and create a diverse portfolio for investors. In other words, they do not place all your eggs in one basket. This diversification significantly reduces the investment risk. For example, imagine that you have 100 million dollars and you invest it all in a high-rise building. Now imagine that you invest that same 100 million dollars in 100 different buildings around the city. Which scenario has a higher risk? In the first scenario, a fire can destroy your entire capital, whereas a fire in the second scenario may only destroy 1 percent of your capital, even if you’re not insured.
Now again, image you invest that 100 million in another kind of investment, such as the stocks of the Bombardier Company. Now imagine that you buy the stocks of several companies with this 100 million (for example the five major banks in Canada, Bombardier, energy companies, a few insurance companies and stapler retailers such as Casco and Walmart). Which option is more risky? In the first case, if the mentioned company goes bankrupt for whatever reason, your entire capital will be gone. But in the second scenario, you will be a stockholder in several companies and there is always the possibility that if one company underperforms, the others make up for it. People who do not have large sums of money are practically unable to diversify their investment porfolio. Even one simple diversification in one limited field (i.e. stocks only) might require purchase of more than 20 different stocks. Even if you buy standard lot (100 shares) of stocks of each of these 20 companies, you will need something around 150,000$ for a diversified set of stocks – assuming that you will purchase the shares of 20 companies.
Mutual funds provide the individuals with this opportunity to diversify their investments, even with a small amount of capital. Because they are buying a part of a fund that has enough money for diversification. A mutual fund worth of billion dollars might own different types of stocks even in different countries, several types of government and provincial bonds, domestic and foreign companies, treasury bills, etc., But you, as a shareholder of this fund, are able to buy a part of this diversified investment with only 1000$. When you buy shares of a mutual fund, you are not buying each and every part of the fund separately, you are purchasing a number of shares/units of the fund that includes a mixture of all types of diversified investments.
Different Types of Mutual Funds correspond to different Risk Profiles: Are you the kind of person who is not worried about losing your money and willing to take huge risks for the possibility of extra capital growth? Or are you the cautious type who is content with a modest growth and is not willing to take high degree of risk? Are you getting close to retirement and only need monthly income and you do not care about capital growth and it is really important to you to keep your principal investment intact?
Investment means something different to each person, because people have different life conditions, income and capital. Everybody loves to circulate their money in the economy so that they can play a positive role in prosperity of the country and receive a share of the profits. People also have different expectations of income and profit. We cannot expect a young 25 year old and a retired 65 year old to invest the same way, in the same place and with the same amount of risk.
In addition to age and different needs, the other factor is risk profile. The degree of risk-taking affects where people choose to invest in. Although this is not a fixed rule, but younger people generally take more risks and can invest in assets that have potential for more growth, whereas older people might prefer a small but certain profit. How much you’re willing to take risks should be evaluated individually. The point is, whatever your situation and risk profile is, a mutual fund is available for you. Some of the mutual funds only invest in Canadian government bonds (which is virtually without any risks). Some only invest in the stocks of known and low-risk companies (five major banks in Canada for example). Some only invest in less-known and small companies with a high growth (and risk) potential and some make investments in a mixture of the mentioned items.
Mutual funds are diverse and are divided into different types. Some funds are suitable for people who want to receive a regular and fixed income. If you are among these people, fixed income funds are appropriate for you. Some of these funds are suitable for people who want to take bigger risks and create the opportunity to make higher profits. Some other funds have taken the middle ground. In other types of classifications, we have funds that invest in different commodities like gold, land, buildings or agricultural products. Instead of entering the market directly, people can buy units of these funds and indirectly take advantage of price fluctuations of their intended commodity in the capital market. In any case, the main point is that there is a fund for every taste and every level of risk-taking, and investors have a wide variety of options.
Easy Process to Purchase and Redeem: All the mutual funds provide various programs and methods of purchasing. From lump sum purchases to installment payments with regular monthly or weekly payments. Selling a stock/unit of a mutual fund is also very simple. As per regulation and at the request of the shareholder (you), the mutual fund company is obligated to deposit the money into the individual’s account within a maximum of 48 hours.
Flexibility in Planning after the Death of an Individual: The good thing about a mutual fund is that it is managed by an expert and not the investor. If the investor has his/her capital in a mutual fund and dies for whatever reason, after the time of death and until the legal steps for distribution of assets are taken, the capital will still be professionally managed. Now if that person was in charge of his/her capitals – stocks of a company for example – and passed away when the market was crashing, none of the inheritors would be allowed to buy or sell the stocks until the legal steps for inheritance were taken.
Accepted as Collateral: Your capital in a mutual fund is acceptable as a collateral for a loan or a line of credit (Although the acceptable percentage must be determined given the floating value of the mutual fund).
Transparency: Mutual funds are required to provide regular reports of their transactions and investment records. This is performed under the transparent and strict laws of Securities Commission. For example, mutual funds present a report of all the investments and possible changes in the value of assets at the end of each financial season. You can easily get the information you want through the website of each mutual fund provider and make an investment in them. Therefore, you can invest in these funds safely and without any concerns. Also, before selling a fund to the investor, the seller is required to present full information about the fund (one of the most important documents that must be provided is known as Fund Facts). Fund Facts is a document that provides standard and key information regarding the fund to the investor, so that the investor will be able to make a correct decision. The language used in the Fund Facts document is simple and comprehensible for the public. In addition, according to Canada’s securities regulation, people involved in selling and providing a mutual fund must be registered and have a license.
Disadvantages of Mutual Funds:
Cost: The advantages of mutual funds are not without any costs. Most mutual funds ask for a percentage of your capital as their fee. This amount ranges from slightly below 1% to a few percent, depending on the fund type.
Unsuitable for Short-term Investments: It is often said that in order to invest in a mutual fund, you must have at least a three-year vision, because shot-term price fluctuations may actually be detrimental to your capital. For example, you might select a fund with an intention of gaining an 8% profit each year and actually earn that much profit, but imagine that annual growth of the fund as this: First year -10%, second year 0% and third year +30%!
This, by all means, does not mean that you will necessarily lose a part of your money in the short-run. You might even gain a huge profit, but you should know that if you’re looking for a short-term investment, mutual funds might not be a good choice. Because when you need money might not be a good time to cash out your share in the mutual fund.
Professional Fund Management Does Not Mean Certain Profit: Although the professional management is mentioned as an advantage of mutual funds, you should bear in mind that no one in the capital market has a fortune-telling crystal ball and even the best managers might underperform some years and whether it’s the general unfavorable conditions of the market or the weak performance of the fund manager, you should keep in mind that although professional management of a mutual investment fund increases your chances of capital growth, it has never been and will not be a guarantee of capital growth.
Classification of Mutual Funds
Mutual funds have various investor types. From risk-taking people who expect high profits to risk adverse people who are satisfied with a small -but safe- profit. That is why mutual funds are categorized based on the risk level, growth potential and their assets type, so that possible customers unfamiliar with different types of securities used in these investment vehicles can make an easier decision. This classification has some standard definitions and terms:
Note: If some of the following terms, especially about investment instruments such as “bond” or “treasury bond” or other similar terms, are vague and ambiguous for you, I recommend reading this article.
Money Market Mutual Funds: According to the definition given by Standard Committee, money market mutual funds are mutual investment funds that invest at least 95% of their capital in money market securities. Money market securities are fixed-income short-term (less than 364 days) securities that can easily be converted into cash. Government treasury bonds are considered as one of the examples of money market mutual funds. In simpler terms, money market mutual funds keep people’s money in short-term bonds. It is very well clear that because the bonds used in this type of fund are short-term and usually government bonds without any risks, the profit gained from this type of fund is very little and only slightly fluctuates based on the bank interest rates (the interest paid by these funds can be compared to GICs). The profit from these funds goes up with the increase in interest rate by government and decreases with the reduction of interest rates. Note that the short term of bonds used in this type of investment has nothing to do with you as an investor. You can keep your money in these funds for years. It is the responsibility of the fund management to replace the expired bonds in the funds with the new ones from time to time. Many banks and investment institutes offer this type of investment fund for customers with very low risk levels. The following can be mentioned as examples of this type of fund:
CIBC Canadian T-Bill Fund – Class A Units or CIBC Money Market Fund – Class A Units or RBC Canadian Money Market Fund
If you visit these websites that contain the information of these funds, you will see that although investment in these funds is very safe and has slight fluctuations, but as I mentioned before, the capital growth is limited. If you visit the links above, you will see that the annual return on investment of these funds is usually less than 1%.
The Figure below shows the paid profit by a money market mutual fund provided by the CIBC Bank.
As you can see, the return on capital in this type of fund is little and in many cases is even less than the inflation rate. In the particular case above, you might have noticed that the return rate of the fund in 1-month and 3-month periods is zero. This is because this report is for December 2020. A few months ago, the Canadian government announced an annual interest rate of 0.25, which is very close to 0. As a result, the short-term capital growth in this fund, due to the use of government bonds, is close to zero. Therefore, in years like 2020 when the bank interest rate has reached its lowest, putting money inside a money market will not have much of a difference with a GIC.
In practice, a money market fund is often used by other types of mutual funds as a temporary place to keep their liquid money (which is almost the same has having cash). Overall, this type of mutual fund has the least amount of risk compared to other types of mutual funds. With that being said, unlike investments with similar interest rates such as GIC, you should know that even this low-risk type mutual fund is not guaranteed by CDIC. By guarantee, I mean being able to cash out if the issuing company goes bankrupt. If you buy this type of mutual fund from a reliable company (for example, one of the major banks in Canada), you probably do not care whether it is guaranteed by CDIC or not, because the possibility of these banks going bankrupt is negligible.
For information: Out of the securities used in money market mutual funds, we can mention federal or provincial treasury bills, commercial papers or short-term corporate banker’s acceptances. According to the law, the average expiration date of the entire fund at any time should be less than 90 days and individually, none of the used bonds should have an expiration date of more than 1 year.
*Money market in brief: very safe in terms of security of the original amount of money, but very small potential for capital growth and income. It is suitable for risk-averse people who cannot tolerate the rise and fall of their capital, even in the short-term.
Example of use: A person who wants to keep the money intended for buying a house in a place until the right time comes.
Mortgage Mutual Funds: Mortgage mutual funds invest most of their capital in high-quality mortgages. In fact, they buy a large number of mortgages from the issuing bank/financial institution. The bank issues mortgage to individuals, and then wraps a large number of mortgages in a package and sells it to a mutual fund. Although people still apparently deal with the bank, it is the latter fund that receives the paid interest by individuals. After issuing a number of mortgages, banks usually put them in a package and sell it to mutual funds. This sale is beneficial both for the bank and for the mutual fund purchasing it. The fund will have a source of income by which it benefits its members. The bank also removes this loan from its financial balance sheet and thus opens the way of providing credit for more mortgages. Norte that, if banks didn’t sell these mortgages to third-party funds, they would have to keep these mortgages in their balance sheets for decades. Considering that there is the risk of non-payment from the mortgagor for some of these mortgages, the law requires the banks to set aside cash assets in a certain proportion and this limits the legal capacity of banks to extend further loans. Therefore, instead of keeping a 20-year mortgage with an annual interest of 5%, they take 1% of its interest and sell the entire mortgage and the remaining 4% annual interest to a mutual fund. Then, the fund becomes the owner of these loans and collect the profits from people – through banks.
Overall, mortgage mutual funds invest most of their capital in high-quality mortgages and a smaller portion of their capital is invested in cash, bonds and mortgage-backed securities. Mortgage mutual funds are classified as “fixed income” mutual funds, because the mortgage rates are largely predetermined. Unlike money market mutual funds that pay a certain amount of profit and the value of the fund’s share does not change, mortgage mutual funds can see an increase in value.
Example: Suppose you have a share/unit in a mortgage mutual fund that has invested in mortgages with a 5% interest rate. Now, if government reduces the interest rate for whatever reason, banks will in turn reduce the interest rate of their mortgages and thus the new mortgages will not be as profitable as the previous ones. Now, if the bank puts these new mortgages in a package and sells it, the result will be a mortgage mutual fund with a -say- 2% profit (instead of the previous 5%). This will lead to an increase in the value of the shares of old mortgage mutual funds (that paid a 5% profit).
Note that not all mortgage mutual funds have the same risk level, but generally speaking, mortgage mutual funds have the second least risk level after money market mutual funds. Some of them only invest in residential mortgages and some other invest in industrial or commercial mortgages. Most mortgage mutual funds make this commitment in their mandate to only invest in high-quality mortgages (like the ones that are insured by the government).
Bond Mutual Funds: As it is evident from the name, bond mutual funds invest mainly in a diverse set of bonds. The main source of income for these funds is the interest they receive from their bonds. But the shares/units of type of funds may see an increase or decrease in value. The main risk of this type of mutual funds is the change in the bank interest rate. If the interest rate goes up, the values of these funds will decline and if the interest rate decreases, their value increases. The next risk is the default risk or the risk of non-payment by the issuer of the bond (i.e. the person who has borrowed money from you is not giving back the profit or your original amount of money). Generally, bond mutual funds are 3rd in terms of low risk-level (after the other two type mentioned above). Although, the risk level of all bond mutual funds is not all the same. Funds that invest a major part of their capital in government bonds have a very small risks compared to those who purchase a significant amount of corporate bonds. The fund can buy a mixture of government, corporate, domestic and foreign bonds to reach the desired balance of risk and profit. You, as an investor, will thus have a choice in selecting a bond mutual fund that matches your risk profile.
Explanation: Suppose you lend somebody money and in return – given the market rate at the time you are lending the money – receive an 8% profit. Now, if the market interest rate drops to 5% for some reason, is it logical for that person to keep the borrowed money? Of course not! He/she will probably return your money immediately and goes to another person to get a loan with a 5% interest rate. Now suppose that person had a contract with you and couldn’t simply go and get another loan from someone else with a 5% interest rate and had to pay that 8% to you until the contract ended. As a result, if you as a lender want to sell (transfer) your profitable loan to someone else, the price that you demand will change based on the market rate.
A Numerical Example: you lend someone a 100000$ loan and receive 8% in return. You have a 10-year contract, meaning that you will get your original amount of money in 10 years and that person will have to pay you 8 thousand dollars each year during this time as interest. This loan is actually a source of income for you and you can sell it – the loan contract – if you want. Maybe someone buys the loan contract for 120 thousand dollars (that person is actually buying an 80 thousand dollar profit in 10 years for 20 thousand dollars in cash today).
On the other hand, imagine, your friend has given 100 thousand dollars to someone as a loan and receives only 3% as interest. Meaning that he will receive his money – like you – in 10 years and during that time, he will receive only 3 thousand dollars as interest (the 100 hundred thousand dollars becomes 130 thousand dollars in 10 years). Now if your friend wants to sell the loan to someone else and retire, maybe someone will buy it for 105 thousand dollars (the person is buying a 30 thousand dollar profit in 10 years for a 5 thousand dollar in cash).
In the condition above, the lower the market interest rate, the more bargaining power you will have in selling your loan. Because if the new investors want to give a loan to someone, they no longer have access to the interest rate you had when you were lending the money and are willing to pay more money to buy your loan. In today’s conditions with Covid-19, the Canadian government has lowered the bank interest rate to almost zero and therefore new government-issued bonds are not attractive for investors and the price of the old ones has increased.
Preferred Dividend Funds: They are a type of mutual fund that tries to earn income from the profit paid to preferred shares of reliable companies.
Note: Although preferred stocks or shares are considered as “stocks”, their properties and conditions are more similar to bonds. This type of stock is usually sold at a fixed price and the company pays a guaranteed profit in proportion to its price. Preferred share is a type of corporate share ownership in which the shareholder has more claims on the assets or profits of the company, compared to common shareholders. The profit received annually by the preferred shareholders might be guaranteed and the company might be obliged to pay a fixed profit. Also, preferred shareholders in most cases have priority in receiving the profits over common shareholders. This means that the company first distributes the end-of-year profits among the preferred shareholders in percentages promised and then distributes the remainder among common shareholders. In return, they are deprived of some privileges such as the right to vote in the general meeting of shareholders. Also, the price of the preferred share is not related to company’s common stock price and does not grow with it.
Keep in mind that although the name of this investment fund is “Preferred dividend fund”, in addition to preferred shares, some of these funds might add the common shares of companies that pay a reliable and regular dividend to their funds.
So far, we have reviewed most of low-risk and cautious mutual funds. The following are funds that have a high risk level, as well as a high potential for capital growth.
Equity mutual Funds: It is a type of mutual fund that invests most of its money in common or preferred shares of public corporations. This type of mutual fund covers a variety of investments. Funds that are in this category, apart from having the same name, can have very different goals and risk levels. For example, one person can have a fixed income with little capital growth and the goal of another person might be maximum capital growth in the long-term without looking for a short-term fixed income.
Note: the income from purchasing a stock has two different sources: 1) it comes from the distribution of income from the net profit at the end of the year which is called dividend. B) It comes from the increase of in the stock price. If you don’t actually sell the stock, that increase will only be on paper and will fluctuate with the increase and decline in stock price
In order to better understand this, pay attention to the following examples.
Example: The main goal of a mutual fund in Canada might be generation of fixed income, while paying slight attention to capital growth. The manager of this fund will probably buy the stocks of a few major banks in Canada. These banks usually give a good end-of-year profit as dividend. However, they are well known and very low-risk corporations that have seen their growth and we shouldn’t expect to see a huge increase in the price of their stocks. The stock price of these banks might increase a few percent in 5-years but during that 5-years, they will distribute a regular annual profit of 4% (for example) among the shareholders.
The goal of another equity mutual fund might be maximum growth of capital in the long run. The manager of this fund will probably buy the stocks of not very well-known corporations that, in his/her opinion, has potential for huge growth. For example, a company that has just recently entered the stock exchange and is working on artificial intelligence. This company will probably pay no profit to its shareholders for a few years and will invest all of its income in itself (its stock price might even go down in short run). but it is projected that in the future with growth and high demand for artificial intelligence, the transactions and the income of this company will multiply and as a result, its stock price will go up substantially and not only will it compensate for the zero profits of the early years, it will actually bring more profits to the investors through stock price appreciation. Although you might be the shareholder of this company for years and receive no profit (from the end of year profit distribution). But if everything goes according to projections, you will be able to sell the stocks of this company with a price 10 times more than the purchase price and make a huge profit. Of course, it is always possible that things do not go according to predictions and your lose your money as well.
It is evident from the two examples above that the stock composition in an equity mutual fund which is the result of the manager’s approach and goal has a substantial effect on the risk level and its growth potential.
According to the goals they pursue, equity mutual funds are divided into a few sub-categories.
1. Standard Equity Mutual Funds: In practice, we do not officially have such a thing as a standard equity mutual fund. We use the term “standard” only because this type of fund is the most common type of equity mutual funds. The goal of a standard fund is to increase the value and profitability through receiving a mixture of profits from dividend distribution and stock price increase. This means that they invest both in companies that have a huge potential for growth and corporations that are really reliable and have a seemingly guaranteed profit (however, they will not grow substantially).
2. Equity Growth Funds: The goal of investing in this type of fund is capital growth. Although it is possible to make an income from the distribution of stock profits, the main goal is to make an investment in stocks that have potential for substantial price growth. These stocks might not yield that much short-term or mid-term income, but they have a capability to see significant growth in the long-term that will make up for the absence of income distribution through the increase in the price of the stock itself. The logic behind investing in this type of fund is that smaller and growing companies have big potentials for growth (unlike huge corporations that will not see a significant growth in their stock price, but you can always be sure of a good annual income that will be distributed among the shareholders).
3. Equity index Funds: Instead of selecting stocks one by one, this type of fund invests in an index. The indices represent the changes of a large number of stocks altogether. For example, the S&P/TSX60 index includes 60 large corporations in Canada’s exchange market. Instead of thinking about which stock is better and worse, the fund purchases a part -or all- of all the 60 big corporations in the exchange market. In other words, these funds tie their destiny to the destiny of the entire stock market or the market segment they buy.
4. Balanced Mutual Funds: This type of fund invests a part of its capital in bonds and another part in stocks. In fact, it is a mixture of an equity fund and a bond fund. The more the amount of bonds in the fund, the more cautious that fund is; and the more the amount of stocks in the fund, the more that fund is willing to take risks for a potential of higher income. Organizations that provide mutual investment funds can provide a wide range of balanced mutual funds for different tastes by changing the percentage of stocks and bonds in the fund. For example: a fund with 20% bonds and 80% stocks, or a 50-50 fund, or a fund with 20% stocks and 80% bonds.
5. Target-date funds: This type of mutual fund has two particular characteristics that makes it different from other types of funds. One is expiration date and the other is something called glide path. Investors of these funds select an expiration date that matches one of the goals in their lives and the fund manager makes an investment based on that date. For example a person decides today to make an investment for his retirement in a target-date fund which expires 20 years later. The fund manager, knowing how long he’s going to have this money and when he’s going to give it back, starts making investments. At first, knowing that there is time to compensate, the manager invests in high risk-level opportunities. But as the due date (time to deliver the money) gets closer, the manager goes on to move the money to low risk level investments.
Global Mutual Funds: Global mutual funds are the ones that instead of focusing on securities in Canada, buy their securities from different countries. In fact, global mutual funds are not a particular type of fund, and all of the above-mentioned types can also be global. But in practice, most global mutual funds are equity mutual funds that invest in stocks in different countries. This type of fund is used for two main reasons: 1- market risk (for example: you think that the economic situation of Canada will not be suitable for a few month or a few year and as a result the economic growth and consequently the exchange market growth will not be favorable, but the growth in European market or Chinese market will be good). 2- Exchange rate risk (For example, you think that oil price will decline and as a result, you predict that the value of Canadian dollar against Japanese Yen will decrease, so instead of investing in Canadian bonds or stocks, you purchase a fund that invests in Japanese stocks.)
Specialty Mutual Funds: This type of mutual fund invests in only a limited field. For example: precious metals fund or natural gas fund or similar cases. You should keep in mind that due to limited field of investments, these types of funds have little diversification compared to other types of funds. For example a specialty mutual fund that invests in gold might try to diversify by investing in the stocks of 10 different companies that provide gold but it is still completely dependent on the gold market and price. No matter how much the entire market booms or crumbles, the value of this fund will only be dependent on the gold price. Bear in mind that on the other hand, ordinary mutual funds invest in a wide range of industries, stocks, and bonds and gold is one of them (For example: financial, industrial, manufacturing, service provider companies and precious metals).
Fund Wraps: It is a type of program that selects a number of mutual funds that have already been founded with specific conditions and goals. For example, after reviewing your conditions, the fund manager concludes that it is better for you to invest 10% of your money in mutual fund No.1 , 20% in mutual fund No.2 and 70% in mutual fund No.3. In fact, a fund wrap consists of a number of different other mutual funds in prescribed percentages.
Example: You want to invest in a fund wrap. The manager of the fund wrap reviews your conditions and reaches the conclusion that you have a medium risk-level and are looking for both capital growth and a little fixed income. As a result, the manager offers the following composition: 10% of a risky mutual fund that has potential for capital growth, 30% of a mutual fund that mostly includes well-known corporations and has a little risk, 30% of a bond mutual fund and 20% of a money market mutual fund.
You might have noticed that what fund wraps do is similar to what balanced mutual funds do. The difference is that balanced mutual funds diversify inside the fund through investing in different types of investment vehicles. For example, they purchase the stocks of various corporations in different industries with different risks. They buy different bonds with different risks and profits and eventually they keep this mixed mixture and, whenever necessary, they change the amount of each of these investment classes to balance the risk, based on the amount they have on their agenda.
In practice, fund wraps intend to do the same thing by selecting different mutual funds, but instead of selecting a composition of different capital classes (stocks, bonds, GIC, etc.), they select pre-existing funds (the funds themselves have different risk profiles according to the items they contain and mixing a number of them can have the decentralizing effect that is required.)
For example, instead of purchasing a mutual fund that invests 50% in bonds (conservative) and 50% in stocks (risky), you could divide your money in half and invest 50% of your money in a mutual fund that invests 100-percent in bonds and the other 50% in another in another mutual fund that invests only in stocks. The former is the same as balanced mutual funds, and the latter is similar to what fund wraps do.