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Two-Fund Separation and HARA Utility Reconsidered

The requirement of existing utility with positive first derivative only makes it possible to derive a restricted two-fund separation theorem for portfolio selection problems with HARA utility replacing the original separation theorem of Cass and Stiglitz (1970). We use our findings for a brief re-examination of the asset allocation puzzle of Canner et al. (1997), of the bias-in-beta problem in mutual funds performance evaluation and of the relevance of the standard CAPM without borrowing restrictions. We also present empirical evidence from performance evaluation for investment funds for the only limited validity of the restricted separation theorem.