Mutual Fund Separation Theorem

In portfolio theory, a mutual fund separation theorem states that, under certain conditions, an investor's optimal portfolio can be assembled by holding a small number of benchmark portfolios, called mutual funds, in the right proportions, rather than by choosing among every individual asset on its own. Because the number of mutual funds needed is smaller than the number of assets available, an investor's own transaction costs can fall, and researchers can derive and test implications for how asset markets function whenever the theorem's conditions genuinely hold. The result underlies the practical case for holding a small number of diversified funds instead of picking securities one at a time.