Applied Investment Theory (AIT) explains how mutual fund managers invest in equities. This is one of modern fnance’s most important questions because mutual funds are the largest investor group in most developed economies, where their management of individuals’ retirement savings is a critical agency relationship.
AIT builds on core principles of standard investment, namely effcient markets and rational investors, and overlays real-world conditions so that: markets are subject to frictions; rationality is conditional on restricted foresight; and risk becomes aversion to loss and uncertainty. AIT also relies on well-recognised fnance concepts: equity value is contingent on state of the world; and equities have attributes of real options, multiple components to their value, and are ranked according to opportunity costs. In addition, mutual funds form a global oligopoly and their revenue is linked to funds under management. These structural influences from markets and the investment management industry combine with moral hazard and agency theory to explain fund managers’ behaviour. Understanding the last addresses the economically important puzzle of funds’ poor fnancial performance.