What is a Mutual Fund Theorem?

The mutual fund theorem is an investment strategy that allows an optimal portfolio construction under given circumstances. According to this theorem, mutual funds can be used exclusively in a portfolio for diversification and optimization. This theory also states that investors need to put their risk capital into a mutual fund that has equivalent securities.

How Does the Mutual Fund Theorem Work?

The mutual fund theorem explains how an investor can construct an optimal investment portfolio, such as choosing to invest their entire risk capital or portfolio in a mutual fund. The mutual fund theorem was introduced by James Tobin alongside Harry Markowitz who worked together between 1955 and 1965. The mutual fund theorem embodies the principles of modern portfolio theory which holds that a portfolio offers the maximum return for each level of risk. This theorem suggests how to build an optimal or constructive portfolio through the use of mutual fund investments.

Modern Portfolio Theory

The mutual fund theorem posits that investors put their risky capital in a single mutual fund given that this portfolio offers the maximum return for the given level of risk. The mutual fund theorem explains the essence of diversification in a portfolio and how it helps limit the level of risk. Mean-variance optimization is crucial to this theorem, it helps to achieve optimal allocation of investments in a portfolio. Drawing insights from the principle of modern theory, the mutual fund theorem provides a basis for building an efficient frontier and hedge risk through diversification and mean-variance optimization.

Mutual Fund Portfolio Construction

The mutual fund theorem helps investors to achieve the maximum return for the entire capital that an investor puts on the line in a portfolio. This theorem explains how an investor can use mutual funds to create an efficient frontier which forms the basis for the capital market. To construct an efficient frontier using mutual funds, the fund is used for optimal investment allocation and diversification. Diversification enhance risk mitigation in a mutual fund portfolio. Generally, the mutual fund theorem explains how an investor can construct an optimal portfolio using mutual funds. A mutual fund portfolio comprises of risk-free assets in the form of Treasury Bills, while an investor can invest in high-quality-debt mutual funds on a short term basis.