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Jul 08

Mutual Fund Theorem – Ignored by most financial advisers

According to John Campbell, Professor of Finance at Harvard, “academic finance has had a remarkable impact on many financial services. Yet, financial planners offering portfolio advice to long-term investors have received curiously little guidance from academic financial economists”.
A case in point is the Mutual Fund Theorem, which was developed by Nobel Laureate, James Tobin in 1958. The mutual fund theorem is a very simple approach to investing based around Harry Markowitz’s efficient frontier framework suggesting that all investors should hold only one portfolio of risky assets. This one portfolio can then be adjusted for the conservative investor by adding risk free assets (or cash), or can be geared for the aggressive investor.
The figure above shows the efficient frontier and the Capital Market Line (CML) which is drawn from the expected return of Cash through the tangent of the efficient frontier (represented by the Optimal Portfolio). Whilst it is not a perfect representation of reality, it demonstrates the possibilities that:
  • By adding cash (or a risk free asset) to the optimal portfolio (which contains bonds, equities, etc) it is possible to achieve a high return for less risk than a portfolio of bonds…this is the benefit of diversification
  • Gearing the optimal portfolio has the ability to achieve a high risk-adjust return than a portfolio of 100% equities. Most of the high growth portfolios include only equities (which clearly may be less efficient than a geared diversified (or optimal) portfolio)

Whilst most if not all financial planners and advisers are aware of the Markowitz efficient frontier and the derivation of the optimal portfolio (i.e. the portfolio with the highest expected return per unit risk), the use of this very simple part of modern portfolio theory has seldom been put into practice. Financial planners throughout the world typically look to personalise portfolios for individual clients based on their risk profile, income and growth needs and most likely looking to build portfolios that are on the efficient frontier. As Figure 1 shows, in theory this may not be the most efficient approach and is potentially creating unnecessary work that adds little to no value in terms of what matters to investors the most, investment returns.

From a practical financial planning perspective, adding cash or gearing an “optimal portfolio” certainly makes things a lot simpler.

Now whilst every investment professional in the world attempts to design an optimal portfolio within their constrained investment universe, we all know that it is impossible, but of course, it doesn’t stop us from trying. For the retail investor the optimal portfolio is often regarded as the “balanced” portfolio, which has a diversified allocation across all available asset classes whether equities, bonds, real assets, etc.

So to really keep portfolio construction simple, recommend the “balanced” fund for the balanced investor and add cash for the more conservative investors and gear into the balanced fund for the growth and high growth investor.

Some of the challenges with implementation include, choosing the optimal portfolio; the limitations of implementation in various investment vehicles such as superannuation where gearing may be difficult; or simply getting cost effective gearing.

Overall, this theorem should provide some food for thought next time a portfolio is constructed and some questions to ask before building the next “tailored” portfolio could be…can a geared diversified portfolio be more efficient than 100% equities or should the client really be out of equities just because they are conservative? At the very least, the Mutual Fund Theorem demonstrates the best method to manage risk is diversification and diversification across all asset classes should be considered irrespective of the investor’s risk profile.

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