The Facts

• Mutual funds are publicly traded securities registered under the Investment Company Act of 1940. They are regulated by the United States Securities and Exchange Commission (SEC). Modern Portfolio Theory attempts to correlate investment risk and return by looking at an entire portfolio rather than merely the underlying securities.
  
  

History

• Mutual funds, at least in their current legal construct, came about as a result of the many changes in the financial regulations resulting from the 1929 market crash and the Great Depression. Modern Portfolio Theory grew out of a series of academic studies beginning with the 1952 paper titled "Portfolio Selection." Although confined to ivy-covered institutions for a decade, the financial industry embraced Modern Portfolio after the development of the Capital Asset Pricing Model by William Sharpe in 1964.
  
  

Significance

• Much of today's investment banking industry relates directly to modern portfolio theory. This includes not only marketing techniques (for example, such terms like "asset allocation"), but also the development of products, including mutual funds. Indeed, one of the more popular mutual fund rating agencies relies on aspects of modern portfolio theory to rate and categorize mutual funds. The mutual fund industry and investors embraced this construct with fervor by the 1990s.
  
  

Misconceptions

• It's more difficult to map mutual funds to the asset class definitions of modern portfolio theory than originally thought. For example, bond funds -- mutual funds that invest in bonds rather than stocks -- behave more like the stock asset class than the bond asset class.
  
  

Expert Insight

• Modern Portfolio Theory has lost much of its luster. For one thing, its definition of risk -- standard deviation -- ranks surpassing a goal as equally "risky" and falling short of a goal. In fact, since the early '60s, the volatility of bonds has grown in relation to stocks, contradicting the expectations of Modern Portfolio Theory. Furthermore, much of the industry use of Modern Portfolio Theory involves using computer models based on past data to predict future returns by building optimized asset allocation portfolios. Ironically, the United States Securities and Exchange Commission requires all investment advisors to always warn clients that "past performance does not guarantee future results."