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.

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An Introduction To Mutual Funds

Understanding the 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.

A portfolio of mutual funds provides even greater risk mitigation from diversification while giving investors exposure to various investments.

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.

Key Takeaways

  • Mutual fund theorem is a strategy used to construct a diversified portfolio with just mutual funds.
  • The theorem subscribes to the modern portfolio theory, where diversification can limit portfolio risk.
  • The mutual fund theorem allows investors to chart an efficient frontier to identify an optimal allocation.

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 an 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.

Similar to modern portfolio theory, investments in risk-free assets are represented by Treasury bills. Farther 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.

Scoring Mutual Funds

Investors looking to find the best mutual funds or the best funds for them should focus on a few key criteria. A standard measure scoring mutual funds is the Fund Investment-Quality Scorecard (FIQS), which helps investors collect key data in an organized way in order to make informed judgments as to the quality of a mutual fund. A FIQS doesn’t include all quantitative data and may include qualitative information, but all info should be quantifiable, such as risk-return profile and return and expense information.

The key criteria for the FIQS include the investment style of the fund, such as what the mutual fund invests in and the manager’s ability to manage those assets accounting to the investment objectives. Beyond that, there’s the risk-return profile, fund size and compatibility, manager tenure and structure, portfolio turnover, mutual fund expenses, total returns, and analyses by research analysts.