Treynor-Black Debacle

A few years back (2007 I think), there was a vignette on this topic. Apparently one had to know how to work the model in details in order to suceed. I was going over the learning outcome for reading 67 (the TB reading), and the LOS says the following: a. JUSTIFY active portfolio mgmt in a nearly efficient mkt. b. DISCUSS the steps to TB security selection c. DESCRIBE how analyst accuracy in forecasting alphas… I wonder if the LOS has changed since 2007. I wonder if CFAI actually respects itsLOS guidelines. Does anyone have a DEFINITIVE or RESEARCHED opinion on this?

There is some information in the beginning of the chapter (I think on the page with the LOSes) that says we are not required to work the model to perform calculations. There was some discussion about this and I think that language is relatively new. You could try doing a forum search for more information.

I am skipping it -

I was there for the T-B bomb. It was definitely a WTF situation. The idea behind it is: 1) although the market is mostly efficient, you may be able to uncover a few mispriced securities by whipping your analyst staff and driving them crazy. 2) You form an optimal portfolio of only those mispriced securities, using mean-variance optimization, and searching for the portfolio that has the maximum sharp ratio among them. Call this the active portfolio (A). 3) The active portfolio has at least some nonsystematic risk in it, so that means that it is not perfectly correlated with the market portfolio (M). Therefore, you get some diversification benefit by combining A with M. This diversification benefit means that you can get a Sharpe Ratio higher than both M’s and A’s Sharpe Ratio by combining the two portfolios in some proportion. That optimal combined portfolio § is what you want to invest in. 4) Remember that, because the market is “mostly efficient,” the implication is that you still get a decent amount of return/risk by investing in the market portfolio, so you don’t want to ignore the market portfolio just because you’ve identified a few good stocks. Other things: 5) Portfolio P, has (wt_a) assets in portfolio A and (wt_m) assets in portfolio M. This is the weight you use if you are perfectly confident in your analyst’s assessments. If you are less confident of your assessments, then you will want to increase the (wt_m) to compensate for the fact that you’re not quite sure your analysts are giving you accurate info. 6) How do you test if your analysts are giving you accurate info? One way is to measure the R^2 of their predictions of alpha. If the R^2 is really low, then you want to discount their assessments and reduce the weight given to the active portfolio. I do not know if you would use (wt_a)*R as the optimal weight, given that you don’t trust your analyst, but that would seem to be a decent guess. The main thing is that T-B is the link between all the stuff in FSA and Equity evaluation and the portfolio management stuff you learn. The curriculum tends to favor efficient markets thinking (less so in recent years; can you guess why?), so you might wonder - if markets are efficient, why all this FSA and Equity evaluation stuff? Well, TB is the way to mix the two skills together. In practice , Treynor-Black has been superseded by Black-Litteran (apparently it can be shown that T-B is a special case of B-L), but the process behind T-B is instructive to seeing how you can combine securities analysis with a “mostly-efficient markets” hypothesis.

You’re the man bchad

Thanks bchad. That was a very nice description of the big picture for T-B theory. Any chance you will record a YouTube pep talk for us L2’ers like you did for the L3’ers a while back?

That was perfect. I just got done reading that section over again and that was dead on to what I just read out of the CFAI book

I don’t think I’ll re-record anything, but the L3 pep talk can work for L2 as well. Remember, be a TOKER!

I worked a TB problem the other night and it took me almost 40 minutes!

I appreciate all the comments, but not many are adressing my concern (which was perhaps unclear). Since the LOS dosen’t instruct us to work the model, is that out of reach for the exam? bchad, has the LOS changed since T-Day?

For anybody who missed it, here is bchad’s pep talk. Definitely helps with the motivation.

johnnyblazini Wrote: ------------------------------------------------------- > I appreciate all the comments, but not many are > adressing my concern (which was perhaps unclear). > > > Since the LOS dosen’t instruct us to work the > model, is that out of reach for the exam? > > bchad, has the LOS changed since T-Day? I know Schweser is saying that you wouldn’t have to be responsible for calculating the TB. (It’d be insane to have to do something similar like the CFAI questions on that section… thats just very… un-CFA-test-likey…) I would say if you get the LOS you mentioned above and know what the TB model equation mean then you should be fine.