Two-Fund Separation and HARA Utility Reconsidered

The requirement of existing utility with positive first derivative only makes it pos-sible to derive a restricted two-fund separation theorem for portfolio selection problems withHARA utility replacing the original separation theorem of Cass and Stiglitz (1970). We useour 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 ofthe standard CAPM without borrowing restrictions. We also present empirical evidence fromperformance evaluation for investment funds for the only limited validity of the restrictedseparation theorem.