An efficient ex-ante criterion for ranking investment strategies

Fisher separation theorem [T.E. Copeland, J.F. Weston, K. Shastri, Financial Theory and Corporate Policy, fourth ed., Addison Wesley, New York, 2005] states that, in a perfect and complete capital market, the investment decisions of a firm are to maximize the wealth of its current shareholders regardless of their preferences. In this study, we integrate Dybvig's [P.H. Dybvig, Inefficient dynamic portfolio strategies or how to throw away a million dollars in the stock market, Review of Financial Studies 1 (1988) 67-88; P.H. Dybvig, Distributional analysis of portfolio choice, Journal of Business 61 (1988) 369-393] payoff distribution pricing model (PDPM) into the framework of this separation theorem and propose that an investment firm with numerous shareholders can use the inefficiency amount of the PDPM as a decision criterion for ranking ex-ante investment strategies in order of their value to the firm. For implementation, we formulate the PDPM in a multiperiod setting and develop an operational formula for computing the inefficiency amount of any strategy. Finally, using simulation, we compare four commonly used fixed-income strategies based on their inefficiency amounts. © 2009 Elsevier Inc. All rights reserved.