Overview
A fund management company is a firm that manages a portfolio of assets for its clients. (the shareholders of the fund)Valuation of a fund that holds liquid securities is fairly simple. Utilizing the Law of One Price, one argues that the value of the fund is the sum of the market prices of the assets of the fund minus the liabilities.
{% price = \sum_i asset_i - \sum_j liab_j %}
Managing a Fund to Maximize Market Value
The purpose of many funds to maximize the fund value. Given the valuation equation, there are only two ways to maximize the value of the fund.- Buy assets at a price lower than market value - if a fund manager can buy an asset at below market value, the difference between the price paid for the asset and the market value of the asset (alpha) should accrue immediately to the shareholders.
- Buy assets that grow over time - this requires some degree of speculation, but fund managers who can pick assets that grow the fastest over time can likewise thus increase the fund value. However, the value will accrue over time as the bets play out.
Diversification Bankruptcy Costs
The valuation equation indicates that the fund value will have nothing to do with how diversified it is. From a theorectical perspective, diversification in and of itself will not add or detract from fund value.There is one recognized exception to this rule, expected bankrupcy costs. If a company incurs costs in the event of bankruptcy, and those costs are borne by the shareholders, then the expected costs should be included when valuing the company.
{% Adj \, Value = Market \, Value \, Assets - \mathbb{E}(Bankruptcy \, Costs) %}
Diversification can reduce the expected costs by reducing the probability of their occurrence.