SUMMATION The Treynor Black model combines market inefficiency and modern portfolio theory. In other words, it combines Active and Passive (indexing) management. This derives from two arguments in favor of active management: Economic (active managers promote market efficiency by arbitraging away mispricings and restoring equilibirum pricing) and Empirical (studies show active management just plain works). ______________________________________ STEPS Step 1 - Develop expectations for passive portfolio M (think “Market” portfolio like in Markowitz’s efficient frontier) Step 2 - Identify mispriced assets Determine each asset’s alpha ------> Alpha = Return on Asset i - Expected Return as calculated by CAPM Step 3 - Determine the optimal weighting in Active Portfolio “A”. We weight the alphas, Betas, and residual variance (think quant = ERROR TERM here folks). Step 4 - Comibine Active “A” and Market “M” portfolios to form Portfolio “P” by summing the squared Sharpe Ratio of M and Information Ratio of A. Choose the combination with the highest overall squared ratio. (Think R2 in quant, Sum of Squares) Step 5 - Allocated to the optimal Portfolio “P” the risk free rate depending upon investor’s desired risk levels within the Capital Allocation Line (CAL). YOU NEED TO KNOW how to determine the investor’s position in the optimal risky portfolio P and the risk free rate (Step 5). This is denoted as -------> -----> y = E(R market portfolio M) - Rf / 0.01 x A (investor’s risk coefficient) x Variance of Portfolio M _____________________________________________- The CFA text says you don’t need to know the calculations for Treynor Black. However, that above equation of solving for the investor’s weighting in “y” (optimal risky portfolio “P”) is not included. Check the text if you disbelieve me. Also, remember to adjust analyst’s alphas by multiplying them by R2.