Mutual Fund Separation Theorem & How It works?

Mutual funds are the most popular kind of funds that an everyday investor is into. The reason, you ask? Well, that's because these investments are simple to understand and easy to use. Mutual fund investments are based upon mutual fund separation theorem which suggests the use of mutual fund investments for building a comprehensive portfolio. The theorem follows the principles of modern portfolio theory and comes with certain advantages for the investors leveraging it.

What Is Mutual Fund?

A mutual fund is an investment that will club your money together with that of other investors to purchase shares of a collection of stocks, bonds, or other securities, referred to as a portfolio, that you won't be able to recreate on your own. A portfolio manager takes care of mutual funds. Professionals manage the holdings comprising the fund's portfolio while investors buy shares that rise or fall in value based on the performance of the fund's underlying securities.

Simply put, if you have invested in mutual funds, you will be owning shares in a company whose business is buying shares in other companies (or in government bonds, or other securities). You won't directly own the stock in the companies the fund purchases, but you'll benefit from the profits or suffer from the fund's total holdings.

Definition Of Mutual Fund Separation Theorem

Mutual fund separation theorem states that any investor's optimal portfolio can be constructed by holding each of certain mutual funds in appropriate ratios. In this case, the number of mutual funds is smaller than the number of individual assets in the portfolio. Here a mutual fund refers to any specified benchmark portfolio of the available assets.

Nobel laureate, James Tobin proposed mutual fund separation theorem also known as mutual fund theorem. According to James, all investor should possess identically comprised portfolio of "risky assets" that they can combine with some percentage of risk-free assets or cash.

Depending on the nature of investors, a conservative investor would follow to have a higher percentage of cash. On the other hand, a risk taker investor would bag some risky investments on his profiles.

Advantages of Mutual Fund Theorem

As mentioned earlier, mutual fund separation theorem clearly states that any investor can contrast its optimal portfolio holding each of certain mutual funds in appropriate ratios. However, it should be noted that the number of mutual funds here, is smaller than the number of individual assets. With that said, this theorem comes with a set of advantages. Have a look at the same:

If an investor fulfills the given requirements, it may be easier for him/her to purchase a smaller number of mutual funds than to purchase a larger number of assets individually.

Second, from a hypothetical and observational point of view, in the event that it very well may be accepted that the applicable conditions are for sure fulfilled, at that point suggestions for the working of benefit markets can be determined and tried.

How Mutual Fund Separation Theorem Works?

To understand the mutual fund separation theorem, let us break it down into the simplest form possible. Consider mutual funds as baskets where every basket contains certain types of stocks, bonds or a combination of both (which can be considered as a mutual fund portfolio). Note that these stocks are not limited to a single nation but are from around the globe. So, all these stocks can be considered as "international".

Now, suppose, an investor buys a fund called ABC International Stock from all the stocks present in the basket. This person is hence considered to be buying one investment security. Though the investor invests in ABC investment security he doesn't own the security itself. He rather buys/owns a representation. In other words, investors own shares of the mutual fund, not shares of the holdings. For instance, if a mutual fund includes shares of stock in Nike (NKE) among other portfolio holdings, the investor is said to hold his own shares of the mutual fund rather than owning Nike stock. He will benefit from an appreciation in the shares of Nike.

What Is Portfolio Separation?

Portfolio separation refers to the theory that states that an investor's choice of a risky investment portfolio is separate from his attitude towards risk. In other words, the theory states that an investor's personal preferences are not at all affected by the construction of a diversified portfolio consisting of both risk-free and risky investments. Rather his/her choices are affected by the net present value of the projected returns. Its implication is that a company's choice of the debt-equity ratio is inconsequential.

So, that was a brief description of mutual funds, mutual fund theorem and its advantages, portfolio separation, and other related elements. These are the kind of concepts that students pursuing higher degrees in finance need to study. Not only do they need to cover vast syllabus with such financial concepts but are also required to work on complex assignments regarding the same. Students depend upon lectures, books written by experts and online resources. Some of the most preferred books on "Mutual Fund Separation Theorem" are:

Book 1:

Mutual Fund Separation Theorem By Frederic P Miller, Agnes F Vandome, John McBrewster (published by International Book Marketing Service Limited, 2011)

Book 2:

Theory of Valuation: Frontiers of Modern Financial Theory By Sudipto Bhattacharya, George M. Constantinides (published by Rowman & Littlefield, 1989)

However, all the information provided in these books may often provide quite a lot of information that would leave the students baffled rather than helping them achieve their academic goals. That's when students are required to turn to online assignment help services. Online assignment writing services like Myassignmenthelp.com step in as saviors when students are desperately looking for a solution amid chaos.

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