What is the Mutual Fund Theorem

The mutual fund theorem is an investing strategy suggesting the use of mutual funds exclusively in a portfolio for diversification and mean-variance optimization.


An Introduction To Mutual Funds

BREAKING DOWN Mutual Fund Theorem

The mutual fund theorem suggests the use of mutual fund investments for building a comprehensive portfolio. The mutual fund theorem was introduced by James Tobin who worked alongside Harry Markowitz from 1955 to 1956 at the Cowles Foundation at Yale University. The mutual fund theorem follows the principles of modern portfolio theory, which Markowitz studied at the Cowles Foundation. Markowitz received the Nobel Memorial Prize in Economic Sciences in 1990 for his work on modern portfolio theory.

Modern Portfolio Theory

The mutual fund theorem explains the importance of diversification in a portfolio and portrays how it can limit portfolio risk. Mean-variance optimization presented by Harry Markowitz forms the basis for the theorem. Given mean-variance optimization from modern portfolio theory techniques, an investor can identify the optimal allocations in a portfolio. Using a universe of investments, an investor can chart an efficient frontier and identify optimal allocations directed by the capital market line for investing. The capital market line is constructed as a type of glide path whereby investors can choose their risk tolerance and invest according to designated allocations at each interval.

Modern portfolio theory provides for a great deal of latitude in the investments used to build the efficient frontier. The assets used in the development of the efficient frontier form the basis for the capital market line. Thus investors can generally shift the capital market line higher by using a universe of higher performing investments at various risk levels.

Mutual Fund Portfolio Construction

Given modern portfolio theory technical analysis, an investor can use modern portfolio theory to create the same graphical representations and coordinates using a universe of mutual funds. An efficient frontier is constructed using mutual funds, and a capital market line is created providing the allocations for diversification. A portfolio of mutual funds provides even greater risk mitigation from diversification while giving investors exposure to various investments.

Similar to modern portfolio theory, investments in risk-free assets are represented by Treasury bills. Further up the capital market line an investor can include greater amounts of higher risk assets such as emerging market equity mutual funds. At the lower end of the spectrum, an investor may invest in short-term, high-quality-debt mutual funds. Overall, the mutual fund theorem suggests that investors can build an optimal portfolio using mutual funds. This type of portfolio can increase diversification. It may also have other advantages such as operational trading efficiencies.