18

Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Dr.
Sohail Zafar

141

Class Twelve
Case For Active Investment Strategy : Treynor- Black Model
Classical portfolio theory of Markowitz and computational simplifications introduced by Sharpe , Lintner,
and Mossin finally led us to conclude that passive investment strategy of allocating your OE between risk
free t-bills and risky market portfolio can satisfy investors of all kinds of risk preferences. Investors can
attain any desired risk-return combination just by changing the weights of X
Rf
and X
m
in their portfolio
and thus moving along CML and SML. More risk averse investors would put bigger proportion of their OE
in risk free t-bill and less risk averse ( risk takers) investors would put a bigger proportion of their OE in
market portfolio. And thus all types of risk preferences are accommodated by this so called Passive
Investment Strategy.

This means life is easy for investors?

In practice, though, there are difficulties in defining any strategy as strictly passive because if portfolio
manager changes proportion of her portfolio, that is X
m
and X
Rf
, due to changing market conditions
within the same year then, strictly speaking, such a strategy is not passive; because manager is involved in
some analysis. Even building portfolios with investment only in M and Rf for target R
p
requires
estimating expected R
m
and SD
m
; so some analysis still has to be done even by a manager following
passive investment strategy. For example a portfolio manager who invests 70% in stocks, 20% in bonds
and 10% in risk free money market mutual fund (MMMF) or t-bills is following passive strategy if she does
not change these proportions due to changing market conditions such as GNP growth rate, interest rate,
money supply, un-employment rate, inflation rate, wars, floods, famines, etc. In real life this is very
unlikely to be the stance of even an avowed passive investment manager.
The conclusive advice based on portfolio theory that investors should build their personal optimal
portfolios of desired risk level and desired return level just by proportioning their OE between M anf Rf
implies no one should do any security analysis to identify mispriced stocks; and no one, therefore, should
attempt to earn abnormally high returns by investing in mispriced stocks. That also implies an unspoken
assumption that all stock are correctly priced in the market on any given day. But then the question arises
that if no one attempts to do security analysis to detect mispriced stocks then there is no reason that
prices of stocks would be at their fair value, meaning there is no reason for assuming market would be
informationaly efficient. It would be the case because due to the lack of attention by security analysts
the prices may not reflect the latest information; and that would violate assumptions of portfolio theory
about prices generally reflecting (incorporating) latest information. It also means death of professional
money management industry; because one major reason for the existence of professional portfolio
management industry such as mutual funds, pension funds, etc, is their presumed ability to earn
Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Dr. Sohail Zafar

142

abnormal rate of return for their clients. And to achieve that aim these professional money managers are
involved in a big way in research to identify mispriced stocks; and then trading buying under-priced stock
and short selling over-priced stocks. This activity of money managers keeps prices in the market close to
their fair value and market, if not perfectly efficient, is still more or less efficient. Moreover some
portfolio managers have shown for number of years abnormally high returns, suggesting they have ability
to beat passive investment strategy by doing security analysis and based on such analysis doing stock
selection thus involving in active investment strategy.

To build a case for active investment strategy which requires doing security analysis to identify mispriced
stocks, let us start by focusing on alpha of stocks, or, as it is called in literature, expected abnormal
returns of a stock.
Expected abnormal return or Alpha of a stock (
i
)
Let us use CAPM formulation for risk adjusted required rate of return on a stock ,i .
R
i
= Rf + (R
m
- Rf) B
i
, say it is 15%
Expected rate of return on a stock is:
R
i
= DPS
1
/ P
0
+ ( P
1
- P
0
) / P
0
, say it is 18%
As expected returns are greater than required returns then stock is mispriced and active
investment manager may want to use such mispriced stocks to earn abnormal returns by taking
long position in those stocks in her portfolio. In fact 18 15 = 3% is called positive alpha for this
stock, or expected abnormal returns. Remember if expected return of a stock is higher than it
required return than, according to CAPM, it is under priced in the market and therefore should
be bought. It can be seen from above formula for expected return: expected Ri is inversely
related with Po; as Po is low, the Ri is high. Therefore stocks whose expected Ri is high (in fact
higher than required Ri from CAPM) then their current Po is low, and they are under-priced at
their current market price.
Another angle to look at alpha of a stock is to take Rf term from RHS to left hand side of CAPM
thus write the CAPM
Ri = Rf + (Rm - Rf) Bi
Then subtract Rf from both sides
Ri Rf = Rf - Rf + (Rm - Rf) Bi, and that simplifies to
Ri Rf = (Rm - Rf) Bi
This is also equation of straight line where intercept , alpha, is assumed to be zero; which means stock is
assumed to be rightly priced in the market. Dependent variable ,Y, is (Ri - Rf), the excess return of stock

143

i; while independent variable ,X, is excess return of market , that is, Rm Rf. Slope of this straight line is
beta of stock i , Bi.
Using the data of past few years of actual Ri, Rf, and Rm, you can estimate alpha and beta of stock i from
this model by running a linear regression. If alpha comes out significantly different from zero, say at 5%
level of significance, you have estimated a model for expected Ri which looks like:
Ri Rf = i + (Rm - Rf)Bi,
Suppose for stock i regression estimates using past data of Ri Rf and Rm Rf, gives alpha of 3%, and
beta of 1.5. Now if for next year you are estimating expected Rm of 20%, and Rf of 12%, then according
to CAPM risk adjusted required return of this stock should be :
Ri = Rf + (Rm - Rf) Bi
= 12 + ( 20 - 12)1.5
= 24%
But expected return of this stock would be:
Ri = i + Rf + (Rm - Rf) Bi (we have brought Rf back to the RHS)
= 3 + 12 + (20 - 12) 1.5
= 27%
expected abnormal return, or alpha = expected return - required return
= 27 - 24
= 3%
Please note LIKE ANY REGRESSION MODEL , this expected return model has error term e
i
in it, expected
value of error term is again assumed zero but it does have a variance VAR e
i
.
Please also note that estimating alpha and beta from the model : Ri Rf = (Rm - Rf) Bi is the method
used in research literature to test CAPM. If alpha comes out significantly different from zero, it is
concluded that CAPM does not hold.

Treynor-Black Mopdel For Active Portfolio Management
An active strategist would like to build an active portfolio, A, by including all such stocks whose alpha are
significant , that is non-non zero, because these are mispriced stocks and therefore abnormal returns can
be earned by taking position in such stocks. It is assumed that most of the stocks are fairly priced and
have zero alpha, only a few are mispriced with non zero alpha. In stocks with positive alpha, long
position; and stocks with negative alpha short position is advised. The resulting portfolio ,A, built by
selecting mispriced stocks therefore should lie above CML.

According to Treynor-Black method, a portfolio managers optimal risky portfolio, K, would be built by
dividing OE between passive portfolio which is market portfolio, M, and her active portfolio, A. while

144

portfolio A. Please remember you learnt in earlier lectures that if there is no perfect correlation
between returns of 2 securities then portfolios made by investing in those 2 securities, such as M and A,
form a curve like curve M to A shown below.

The graph below shows that active portfolio manager would try to build her active portfolio ,A, in a
manner that when she divides investment between A and M she gets curve M to A such that the line
emerging from RF and touching the curve M to A has highest possible slope. And at the point where line
emerging from Rf just touches the curve M to A is a portfolio, let us call it portfolio K , her optimal risky
portfolio.

As we saw earlier while dividing OE between M and Rf in different proportions you can built portfolios
that arrange themselves on a straight line on the graph where y-axis is Rp and x-axis is SDp; here also
proportioning OE between K and Rf in different proportions, you can build many portfolios that, when
placed on graph, would arrange themselves as a straight line emerging from Rf and passing through
portfolio ,K, and extending till infinity. This straight line is called Capital Allocation Line ( CAL) of that
particular portfolio manager, as shown in chart below. Performance of that particular active portfolio
manager would be judged by the slope of her CAL on which each dot is a portfolio that can be built by
investing in Rf and K. Note portfolio A, the active portfolio built by actively selecting mispriced stocks is
not on CAL but must be above CML. Portfolio A is her active portfolio because she decided that these few
stocks are mispriced and included those to build portfolio A; another portfolio manager may identify a
different set of mis-priced stock and end up building a different active portfolio. Therefore the resulting
CAL for 2 managers would be different.
You know that Sharpe ratio is )Rp Rf) / SDp; and it is a measure of portfolio managers performance
because it is showing excess return earned by a portfolio per unit of total risk. Portfolio K has, by
definition, a Sharpe ratio higher than the Sharpe ratio of the same risk portfolio on CML. So portfolio K is
a superior performing portfolio on a risk adjusted basis than a comparable risky portfolio on CML.
Comparable here means a portfolio on CML whose risk (SDp) is same as SD of portfolio K. In other words
excess return per unit of total risk ratio of portfolio K: ( R
K
R
f
) / SD
K
is more than excess return to total
risk ratio of the same risk portfolios on CML. Since excess return to total risk ratio is in fact slope of a
straight line; as discussed in previous lecture, therefore if portfolio K has higher excess return to total risk
ratio than the same risk portfolio on CML, then it means that portfolio K lies on a straight line (CAL)
whose slope is more than CML, as shown below.


145

The curved line joining M with A and passing through K is a sort of new efficient frontier she is trying to
create; and this efficient frontier lies above Markowitz efficient frontier, and also above CML which is the
efficient frontier when risk free lending and borrowing is allowed. This curve M to A is composed of
portfolios built by dividing OE between M and A, as shown below. Portfolio K is on the curve M to A and
is made up by investing in these 2 securities. Portfolio K is shown as falling on a straight line emerging
from Rf, it is a steeper sloping line than CML; and it is called CAL (Capital Allocation Line) for portfolio K.
All dots on this CAL are portfolios that can be built by dividing OE between Rf and K; while portfolio K
itself is built by dividing funds between portfolio M and portfolio A; and portfolio A itself is built by
investing in mispriced stocks; and mispriced stocks were defined as stocks with non zero alpha.

To achieve this aim, the active portfolio A must lie above CML. Dividing funds between active portfolio,
A, and passive portfolio M, results in active strategists optimal risky portfolio, K. Please note passive
portfolio is another name used for market portfolio, M, because investing in market index funds requires
no active stock selection. Then investing proportion of her OE in K and Rf can take her to any point on
CAL. The more risk taker she is , bigger proportion of OE she puts in K, that is, a bigger X
K
and more risk
averse she is a bigger proportion of her OE she puts in risk free t-bill, that is, a bigger X
Rf
.

The question that was answered by Treynor-Black model was: how to find weights of portfolio K which is
built by combining portfolios M and A; in other words how to find X
m
and X
A
for portfolio K. But to do
that you need to find weights of mispriced stocks included portfolio A, that is X
i
of each mispriced stock
to be included in the actively selected portfolio A.

Let us see the solution offered by Treynor and Black. Weights of optimal risky portfolio , K are: X
m
+ X
A
,
and that must add up to one like weights of any other portfolio. That means X
m
+ X
A
= 1, therefore you

K A
M
R
f

SD
P

CAL
CML

146

can write: X
M
= 1 - X
A
. And sum of the weights of portfolio K can be written as: X
A
+ (1 - X
A
) = 1. And
question boils down to: What should be weight of active portfolio, A, and passive portfolio , M, in the
optimal risky portfolio K. Portfolio K is being called optimal because it is built in a manner so that slope of
straight line called CAL is maximized; and therefore Sharpes ratio is higher for portfolios on CAL than
portfolios on CML if the SD is same. But weight of A cannot be found without first finding weights of
mispriced stocks included in active portfolio A.

Note that portfolio A, your active portfolio was built by investing in mispriced stocks, and has the
following features like any other portfolio:
VAR
A
= B
A
2
VAR
m
+ VAR e
A

Also: COV
A, m
= B
A
B
m
VAR
m ,
but since B
m
is one by definition , so: COV
A, m
= B
A
VAR
m

As a first step we find:
X
A in K if beta of A is 1
= (
A
/ VAR e
A
) / {(R
m
Rf) / VAR
m
}

This is optimized solution was found using an algorithm for weight of portfolio A in portfolio K so that
slope of CAL is maximized. But this formula is applicable only if beta of actively selected portfolio ,A, is
one.
Then find weight of active portfolio A in portfolio K without restriction of beta of being one:
X
A
= X
A ink when beta of A is 1
/ [1 + (1 - B
A
)X
A in K when beta of A is 1
]

So optimal portfolio ,K, is built up by investing in only 2 securities, namely, portfolio M and portfolio A.
The weights of portfolio K are: X
M
+ X
A
= 1. Which means X
M
=(1 - X
A
). So if you have found weight of
A, the problem is solved; and formula above give weight of portfolio A in K. In the above formula:

A
= weighted average of alphas of mispriced stocks. And B
A
is weighted average of betas of mispriced
stocks. And VAR e
A
is weighted average of VAR e of mispriced stocks BUT weights are squared. All these
features of a portfolio you already know from previous lectures.

Similar to ratio of alpha of active portfolio to its diversifiable risk is(
A
/ VAR e
A
) shown above, a ratio for
each mispriced stock i is calculated as:
i
/ VAR e
i
. For each stock the ratio of its alpha to diversifiable
risk can be viewed as stocks advantage to disadvantage ratio; because including mispriced stock in
portfolio A has advantage of earning alpha abnormal returns but such inclusion also amounts to
deliberately taking diversifiable risk present in that stock which would result in higher diversifiable risk of
portfolio A, and that is a disadvantage. In the same vein, building portfolio composed of a few mispriced
stocks would result in an active portfolio A having an alpha (
A
), that is, expected abnormal returns; but
also disadvantage of being a portfolio that is not fully diversified and has (a big) diversifiable risk in it, that

147

is, a big (VAR e
A
). Therefore if the ratio of advantage to disadvantage is big for a stock, there is
justification of including that stock in active portfolio A. And also if actively built portfolio using
mispriced stocks , A, has big ratio of advantage to disadvantage then there is justification for doing stock
selection and building portfolio A. In short the justification for doing active investment strategy that
requires searching for mispriced stocks and thereby getting into stock selection, and not following the
passive strategy of investing in M & Rf, is the above mentioned ratio of advantage to disadvantage.
The weight of each mispriced stock X
i
in active portfolio , A, is : (
i
/ VAR e
i
) / (
i
/ VAR e
i
).

Sum of the squares of advantage to disadvantage ratio (
i
/ SD e
i
) for all the mispriced stocks give the
square of the advantage to disadvantage ratio for the active portfolio , A:
[(
i
/ SD e
i
)]
2
= [ (
A
/ SD e
A
)]
2
. And ratio [
A
/ SD e
A
] ,that is, advantage to disadvantage ratio for
portfolio A, is also called Information Ratio of active portfolio, A. It gives contribution of active portfolio
A in Sharpe ratio of portfolio K. Please remember that by definition Sharpe ratio of portfolio K is bigger
than Sharpe ratio of same risk portfolio on CML because slope of CAL is more than slope of CML; and
Sharpe ratio is in fact this slope. Since portfolio K is made up of investment in a passive portfolio M and
investment in an actively selected portfolio A, therefore Sharpe ratio of portfolio K is affected by Sharpe
ratio of market portfolio M, that is, (Rm - Rf) / SDm; and also by Information ratio of active portfolio A,
that is,
A
/ SD e
A
. So this methodology of Treynor and Black allows you to bifurcate the square of
Sharpe ratio of portfolio K into 2 components, that is, [( R
K
R
f
) / SD
K
]
2
has 2 components as shown
below:
Square of Sharpe ratio of K = square of Sharpe ratio for M + square of information ratio of A
[( R
K
R
f
) / SD
K
]
2

= [(Rm - Rf ) / SDm]
2
+ [ (
A
/ SD e
A
)]
2

The second term on the RHS is the improvement in square of Sharpe ratio of portfolio K due to active
investment strategy of identifying mispriced stocks and then building a portfolio called here active
portfolio, A, in a manner that funds divided between portfolio M and portfolio A result in your optimal
portfolio ,K , which has a Sharpe ratio higher than Sharpe ratio of the same risk portfolio on CML, and
thus portfolio K falls on a straight line called CAL (capital Allocation Line) which has higher slope than CML,
and thus CAL offers a superior risk return trade off than CML. And in fact that particular portfolio
manager may now treat her CAL as efficient frontier for HER. But do not forget that each portfolio
manager may have a different CAL, meaning different sloping CAL.

M
2
: A measure for Performance of Active Portfolio Manager
Let us say that an active manager builds a portfolio, portfolio O, falling on CAL by dividing her OE between
risk free t- bills and optimal risky portfolio K in a manner that portfolio O has same total risk as the total
risk of the market, that is, SD
o
is same as SD
m
. You can calculate difference between excess returns of

148

portfolio O and M, and this would be a good measure of performance of portfolio manager on a risk
adjusted basis because both portfolios, O & M, have same SD, therefore their Sharpe ratios have same
denominator, that is SDm, but have different excess returns: that is (Ro Rf) for portfolio O; and (Rm - Rf)
for portfolio M. Difference in their Sharpe ratios or in other words difference in their excess returns is
called Modigliani square or M
2
.
What are the weights of risk free security and portfolio K in portfolio O when portfolio O has same risk as
market portfolio? In other words what is X
Rf
and X
K
in portfolio O.
You can find these weights as: X
Rf
+ X
K
=1, so X
Rf
= 1 - X
K
. And X
k
has been solved as:
X
K
= SD
m
/ SD
K

X
Rf
= (1 - SD
m
/ SD
K
)
Build portfolio O with these weights and then find excess returns of portfolio O. Once portfolio O has
been built then you can compare its Sharpe ratio with Sharpe ratio of market portfolio, since it is on a
higher sloping line than CML, so its Sharpe ratio is likely to be higher. The difference between Sharpe
ratios of portfolio O and Sharpe ratio of portfolio M is called M
2
. Bigger this difference, better is the
performance of active portfolio manager on a risk adjusted basis; and justified is her active investment
strategy of searching for mispriced stocks and building active portfolio, A, and then mixing A with M to
build K.
Then M
2
= Sharpe ratio of portfolio O - Sharpe ratio of market portfolio
= (R
O
- Rf) / SD
O
- (Rm - Rf) / SD
m

Since Portfolio O was constructed in a manner to have its SDo same as SDm, therefore denominator of
Sharpe ratios of both the portfolio is same and you can just compare their excess returns.
M
2
= Excess return of portfolio O - Excess return of M
Exercise:
Using the data of past returns, the following has been estimated by your staff of security analysts about
stocks and have discovered 3 mispriced stocks:
SD
ei
VAR
ei
/ SD
ei
/ VAR
ei

PSO 7% 1.6 0.45 0.2025 0.15556 0.3457
Lever -5 1 0.32 0.1024 -0.1563 -0.4883
ICI 3 0.5 0.26 0.0676 0.1154 0.4438
Sum = 0.3012
Expected return of market (R
M
) is 20%, total risk of market (SD
M
) is 0.2 or 20%, Risk-free returns from one-
year maturity t-bills are 12%. Note VAR
M
= (SD
M
)
2
= 0.2
2
= 0.04. Please note Sd and VAR are
deliberately in decimal format for the ease of calculations


149

Q1
Find Weight of actively selected portfolio, A, so that the resulting optimal portfolio K built by dividing OE
between A and M is such that when a straight line emerging from RF passes through K , its slope is
highest.
Xi in A =
i
/ VAR
ei
/ sum of
i
/ VAR
ei

X
PSO
= 0.3457 / 0.3012 = 1.14774
X
Lever
= -0.4883 / 0.3012 = -1.6212
X
ICI
=

0.4438 / 0.3012 =1.4735
Sum = 1
Q2
Find Alpha of Active portfolio A (
A
)
X
PSO
PSO
+

X
Lever

Lever
+

X
ICI
ICI
1.14774 *7 + -1.6212 *-5 + 1.4735 * 3 = 20.56% or 0.2056

Q3
Find beta of active portfolio A (
A
)
X
PSO

PSO
+

X
Lever

Lever
+

X
ICI
ICI

1.14774 *1.6 + -1.6212 *1 + 1.4735 * 0.5 = 0.9519

Q4
Find diversifiable risk of active portfolio ( VAR
e A
)
X
2

PSO
VAR
e

PSO
+

X
2

Lever
VAR
e Lever
+

X
2

ICI
VAR
e ICI

(1.14774)
2
*0.2025 + (-1.6212)
2
* 0.1024 + (1.4735)
2
* 0.0676 = 0.68245

SD e
A
= 0.68245 = 0.8261
Q5
Find total risk of active portfolio ,A, (VAR
A
)

2
P
VAR
M
+ VAR
e A

(0.9519)
2
* 0.04 + 0.68245
0.03624 + 0.68245
0.71864

SD
A
= 0.71864 = 0.8477


150

Please note total risk (SD ) of active portfolio is much higher (0.8477) than the total risk of market
portfolio, which is only 0.2 as given above in data. So active portfolio is a very high risk portfolio ; almost
4 time as risky than the market. Most of its risk is diversifiable; in fact almost 94% of its total risk is
diversifiable (0.6824 / 0.71864 = 0.94). So it is not a well diversified portfolio; and that is understandable
because it was built by using only 3 stocks.

Q6
Please find expected rate of return of active portfolio ,A ?
R
A
= X
PSO
R
PSO
+

X
Lever
R
Lever
+

X
ICI
R
ICI
But we do not have Ri for each stock so let us first find expected Ri of each stock using
Ri = i + Rf + (Rm - Rf) Bi
R
PSO
= 7 + 12 + (20 -12)1.6 = 31.8%
R
Lever
= -5 + 12 + (20 -12) 1 = 15%
R
ICI
= 3 + 12 + (20 -12) 0.5 = 19%
Then inserting these ROrs of stocks in portfolio return formula given above you got

R
A
= X
PSO
R
PSO
+

X
Lever
R
Lever
+

X
ICI
R
ICI
R
A
=1.14774 *31.8 + -1.6212 *15 + 1.4735 * 19

= 36.49 + -24.32 + 27.99
= 40.17%
OR you can find it as
R
A
=
A
+ Rf + (R
M
- Rf) B
A

= 20.56 + 12 + (20 - 12) 0.9519
= 40.17%

Q7
Build optimal risky portfolio, K, by investing in 2 securities, namely active portfolio ,A, and passive
portfolio, M; that is, find weight of active portfolio A, in optimal portfolio K; and weight of market
portfolio M in optimal portfolio K.
Please remember when correlation between 2 securities returns is not perfect, then portfolios built by
combining these 2 securities in different proportions lie on a curve like shown below in risk return space


151

Therefore all combinations of A and M will fall on such a curve; so would portfolio K and weights of K are
X
M
and X
A
. On previous pages formula for weight of active portfolio A in optimal portfolio K was given as
as:
X
A in K if beta of A is 1
= (
A
/ VAR e
A
) / {(R
m
Rf) / VAR
m
}
= (0.2056 / 0.68245) / {(0.2 - 0.12) / 0.04} = 0.15064

X
A
= X
A ink when beta of A is 1
/ [1 + (1 - B
A
)X
A in K when beta of A is 1
]
= 0.15064 / [1 + (1 - 0.9519)* 0.15064] = 0.14956

X
M
= 1 - X
A

= 1 - 0.14956
= 0.85044

Q8
Find weight of 3 stocks in portfolio K
X
PSO in K
= X
PSO in A
* X
A in K
= 1.1477 * 0.14956 = 0.17165 or 17.165% of your OE
X
Lever in K
= X
Lever in A
* X
A in K
= -1.6212 * 0.14956 = -0.2424 or 24.24% of your OE
X
ICI in K
= X
ICI in A
* X
A in K
= 1.4735 * 0.14956 = 0.2202 or 22.02% of your OE
Double check these weights add up to 0.14965, that is weight of active portfolio A in optimal portfolio K

Q9
Show final weights of optimal portfolio K
X
PSO in K
+ X
Lever in K
+ X
ICI in K
+ X
M in K

0.17165
K
+ -0.2424 + 0.2202 + 0.85044 = 1

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