Asset Management

Lecture 6

Outline for today

Treynor

Black Model
M2 measure of performance
Sensitivity to return assumption
Tracking error

Treynor Black Model

The

optimization of a risky portfolio using

a single-index model is know as the
Treynor Black model (or diagonal model)

Optimizing procedure
a
w = 2i
(ei )
0
i

wi =

i =1

i =1

0
i

A = wi i
i =1

(e A ) = wi2 2 (ei )

a A = wi ai

w
i =1

aA
2

(e A )
0
wA =
E ( RM )
M2

0
i

0
w
A
w*A =
1 + (1 A ) w0A

w = 1 w
*
M

*
A

E ( R p ) = ( wM* + w*A A ) E ( RM ) + w*A A

P = (w + w A ) + w ( eA )
*
M

*
A

2
M

*
A

Treynor Black Model

Sp =

E(Rp )

( wM* + w*A A ) E ( RM ) + w*A A

*
A

ai

S = S +
i =1 (ei )
2
p

2
M

(w + w A ) + w ( eA )
*
M

2
M

*
A

Table 27.1 active portfolio

management with 6 assets
wi0 =

ai
2 (ei )
S&P 500 Active Pf A

HP
2

(e)
2

0.5505 / (e)
1.0000 W0 (i)

[W0 (i)]
A

DELL

WMT

TARGET

BP

SHELL

0.0705

0.0572

0.0309

0.0392

0.0297

0.0317

0.2126

-0.1748

-0.1619

0.1911

0.4045

0.0789

0.3863

-0.3176

-0.2941

0.3472

0.7349

0.1433

0.1492

0.1009

0.0865

0.1205

0.5400

0.0205

0.0663

-0.0546

-0.0505

0.0596

0.1262

0.0246

0.0663
0.0750
0.3817

-0.0546
0.1121
0.2901

-0.0505
0.0689
0.1935

0.0596
0.0447
0.2611

0.1262
0.0880
0.1822

0.0246
0.0305
0.1988

0.0222

(eA)

0.0404

W0
W*
Beta
Risk premium
SD
Sharpe Ratio
M-Square

0.1691
0.8282
1
0.06
0.1358
0.44
0

Overall
0.1718 Portfolio
1.0922
0.0878
0.2497
0.35
-0.0123

1.0158
0.0648
0.1422
0.4556
0.0019

Table 27.1 active portfolio

management with 6 assets
wi =

wi0
n

w
i =1

0
i
S&P 500 Active Pf A

HP
2

(e)
2

0.5505 / (e)
1.0000 W0 (i)

[W0 (i)]
A

DELL

WMT

TARGET

BP

SHELL

0.0705

0.0572

0.0309

0.0392

0.0297

0.0317

0.2126

-0.1748

-0.1619

0.1911

0.4045

0.0789

0.3863

-0.3176

-0.2941

0.3472

0.7349

0.1433

0.1492

0.1009

0.0865

0.1205

0.5400

0.0205

0.0663

-0.0546

-0.0505

0.0596

0.1262

0.0246

0.0663
0.0750
0.3817

-0.0546
0.1121
0.2901

-0.0505
0.0689
0.1935

0.0596
0.0447
0.2611

0.1262
0.0880
0.1822

0.0246
0.0305
0.1988

0.0222

(eA)

0.0404

W0
W*
Beta
Risk premium
SD
Sharpe Ratio
M-Square

0.1691
0.8282
1
0.06
0.1358
0.44
0

Overall
0.1718 Portfolio
1.0922
0.0878
0.2497
0.35
-0.0123

1.0158
0.0648
0.1422
0.4556
0.0019

Table 27.1 active portfolio

management with 6 assets
n

a A = wi ai
i =1

S&P 500 Active Pf A

HP
2

(e)
2

0.5505 / (e)
1.0000 W0 (i)

[W0 (i)]
A

DELL

WMT

TARGET

BP

SHELL

0.0705

0.0572

0.0309

0.0392

0.0297

0.0317

0.2126

-0.1748

-0.1619

0.1911

0.4045

0.0789

0.3863

-0.3176

-0.2941

0.3472

0.7349

0.1433

0.1492

0.1009

0.0865

0.1205

0.5400

0.0205

0.0663

-0.0546

-0.0505

0.0596

0.1262

0.0246

0.0663
0.0750
0.3817

-0.0546
0.1121
0.2901

-0.0505
0.0689
0.1935

0.0596
0.0447
0.2611

0.1262
0.0880
0.1822

0.0246
0.0305
0.1988

0.0222

(eA)

0.0404

W0
W*
Beta
Risk premium
SD
Sharpe Ratio
M-Square

0.1691
0.8282
1
0.06
0.1358
0.44
0

Overall
0.1718 Portfolio
1.0922
0.0878
0.2497
0.35
-0.0123

1.0158
0.0648
0.1422
0.4556
0.0019

Table 27.1 active portfolio

management with 6 assets
n

(e A ) = wi2 2 (ei )
2

i =1

S&P 500 Active Pf A

HP
2

(e)
2

0.5505 / (e)
1.0000 W0 (i)

[W0 (i)]
A

DELL

WMT

TARGET

BP

SHELL

0.0705

0.0572

0.0309

0.0392

0.0297

0.0317

0.2126

-0.1748

-0.1619

0.1911

0.4045

0.0789

0.3863

-0.3176

-0.2941

0.3472

0.7349

0.1433

0.1492

0.1009

0.0865

0.1205

0.5400

0.0205

0.0663

-0.0546

-0.0505

0.0596

0.1262

0.0246

0.0663
0.0750
0.3817

-0.0546
0.1121
0.2901

-0.0505
0.0689
0.1935

0.0596
0.0447
0.2611

0.1262
0.0880
0.1822

0.0246
0.0305
0.1988

0.0222

(eA)

0.0404

W0
W*
Beta
Risk premium
SD
Sharpe Ratio
M-Square

0.1691
0.8282
1
0.06
0.1358
0.44
0

Overall
0.1718 Portfolio
1.0922
0.0878
0.2497
0.35
-0.0123

1.0158
0.0648
0.1422
0.4556
0.0019

Table 27.1 active portfolio

management with 6 assets
aA
2 (e A )
0
wA =
E ( RM )
M2
S&P 500 Active Pf A

HP
2

(e)
2

0.5505 / (e)
1.0000 W0 (i)

[W0 (i)]
A

DELL

WMT

TARGET

BP

SHELL

0.0705

0.0572

0.0309

0.0392

0.0297

0.0317

0.2126

-0.1748

-0.1619

0.1911

0.4045

0.0789

0.3863

-0.3176

-0.2941

0.3472

0.7349

0.1433

0.1492

0.1009

0.0865

0.1205

0.5400

0.0205

0.0663

-0.0546

-0.0505

0.0596

0.1262

0.0246

0.0663
0.0750
0.3817

-0.0546
0.1121
0.2901

-0.0505
0.0689
0.1935

0.0596
0.0447
0.2611

0.1262
0.0880
0.1822

0.0246
0.0305
0.1988

0.0222

(eA)

0.0404

W0
W*
Beta
Risk premium
SD
Sharpe Ratio
M-Square

0.1691
0.8282
1
0.06
0.1358
0.44
0

Overall
0.1718 Portfolio
1.0922
0.0878
0.2497
0.35
-0.0123

1.0158
0.0648
0.1422
0.4556
0.0019

Table 27.1 active portfolio

management with 6 assets
n

A = wi i
i =1

S&P 500 Active Pf A

HP
2

(e)
2

0.5505 / (e)
1.0000 W0 (i)

[W0 (i)]
A

DELL

WMT

TARGET

BP

SHELL

0.0705

0.0572

0.0309

0.0392

0.0297

0.0317

0.2126

-0.1748

-0.1619

0.1911

0.4045

0.0789

0.3863

-0.3176

-0.2941

0.3472

0.7349

0.1433

0.1492

0.1009

0.0865

0.1205

0.5400

0.0205

0.0663

-0.0546

-0.0505

0.0596

0.1262

0.0246

0.0663
0.0750
0.3817

-0.0546
0.1121
0.2901

-0.0505
0.0689
0.1935

0.0596
0.0447
0.2611

0.1262
0.0880
0.1822

0.0246
0.0305
0.1988

0.0222

(eA)

0.0404

W0
W*
Beta
Risk premium
SD
Sharpe Ratio
M-Square

0.1691
0.8282
1
0.06
0.1358
0.44
0

Overall
0.1718 Portfolio
1.0922
0.0878
0.2497
0.35
-0.0123

1.0158
0.0648
0.1422
0.4556
0.0019

Table 27.1 active portfolio

management with 6 assets
wA0
w =
1 + (1 A ) w0A
*
A

S&P 500 Active Pf A

HP
2

(e)
2

0.5505 / (e)
1.0000 W0 (i)

[W0 (i)]
A

DELL

WMT

TARGET

BP

SHELL

0.0705

0.0572

0.0309

0.0392

0.0297

0.0317

0.2126

-0.1748

-0.1619

0.1911

0.4045

0.0789

0.3863

-0.3176

-0.2941

0.3472

0.7349

0.1433

0.1492

0.1009

0.0865

0.1205

0.5400

0.0205

0.0663

-0.0546

-0.0505

0.0596

0.1262

0.0246

0.0663
0.0750
0.3817

-0.0546
0.1121
0.2901

-0.0505
0.0689
0.1935

0.0596
0.0447
0.2611

0.1262
0.0880
0.1822

0.0246
0.0305
0.1988

0.0222

(eA)

0.0404

W0
W*
Beta
Risk premium
SD
Sharpe Ratio
M-Square

0.1691
0.8282
1
0.06
0.1358
0.44
0

Overall
0.1718 Portfolio
1.0922
0.0878
0.2497
0.35
-0.0123

1.0158
0.0648
0.1422
0.4556
0.0019

Table 27.1 active portfolio

management with 6 assets
w = 1 w
*
M

*
A

S&P 500 Active Pf A

HP
2

(e)
2

0.5505 / (e)
1.0000 W0 (i)

[W0 (i)]
A

DELL

WMT

TARGET

BP

SHELL

0.0705

0.0572

0.0309

0.0392

0.0297

0.0317

0.2126

-0.1748

-0.1619

0.1911

0.4045

0.0789

0.3863

-0.3176

-0.2941

0.3472

0.7349

0.1433

0.1492

0.1009

0.0865

0.1205

0.5400

0.0205

0.0663

-0.0546

-0.0505

0.0596

0.1262

0.0246

0.0663
0.0750
0.3817

-0.0546
0.1121
0.2901

-0.0505
0.0689
0.1935

0.0596
0.0447
0.2611

0.1262
0.0880
0.1822

0.0246
0.0305
0.1988

0.0222

(eA)

0.0404

W0
W*
Beta
Risk premium
SD
Sharpe Ratio
M-Square

0.1691
0.8282
1
0.06
0.1358
0.44
0

Overall
0.1718 Portfolio
1.0922
0.0878
0.2497
0.35
-0.0123

1.0158
0.0648
0.1422
0.4556
0.0019

Table 27.1 active portfolio

management with 6 assets
E ( R p ) = ( wM* + w*A A ) E ( RM ) + w*A A
S&P 500 Active Pf A

HP
2

(e)
2

0.5505 / (e)
1.0000 W0 (i)

[W0 (i)]
A

DELL

WMT

TARGET

BP

SHELL

0.0705

0.0572

0.0309

0.0392

0.0297

0.0317

0.2126

-0.1748

-0.1619

0.1911

0.4045

0.0789

0.3863

-0.3176

-0.2941

0.3472

0.7349

0.1433

0.1492

0.1009

0.0865

0.1205

0.5400

0.0205

0.0663

-0.0546

-0.0505

0.0596

0.1262

0.0246

0.0663
0.0750
0.3817

-0.0546
0.1121
0.2901

-0.0505
0.0689
0.1935

0.0596
0.0447
0.2611

0.1262
0.0880
0.1822

0.0246
0.0305
0.1988

0.0222

(eA)

0.0404

W0
W*
Beta
Risk premium
SD
Sharpe Ratio
M-Square

0.1691
0.8282
1
0.06
0.1358
0.44
0

Overall
0.1718 Portfolio
1.0922
0.0878
0.2497
0.35
-0.0123

1.0158
0.0648
0.1422
0.4556
0.0019

Table 27.1 active portfolio

management with 6 assets
[

P = ( wM* + w*A A ) 2 M2 + w*A ( e A )

S&P 500 Active Pf A

HP
2

(e)
2

0.5505 / (e)
1.0000 W0 (i)

[W0 (i)]
A

DELL

WMT

TARGET

BP

SHELL

0.0705

0.0572

0.0309

0.0392

0.0297

0.0317

0.2126

-0.1748

-0.1619

0.1911

0.4045

0.0789

0.3863

-0.3176

-0.2941

0.3472

0.7349

0.1433

0.1492

0.1009

0.0865

0.1205

0.5400

0.0205

0.0663

-0.0546

-0.0505

0.0596

0.1262

0.0246

0.0663
0.0750
0.3817

-0.0546
0.1121
0.2901

-0.0505
0.0689
0.1935

0.0596
0.0447
0.2611

0.1262
0.0880
0.1822

0.0246
0.0305
0.1988

0.0222

(eA)

0.0404

W0
W*
Beta
Risk premium
SD
Sharpe Ratio
M-Square

0.1691
0.8282
1
0.06
0.1358
0.44
0

Overall
0.1718 Portfolio
1.0922
0.0878
0.2497
0.35
-0.0123

1.0158
0.0648
0.1422
0.4556
0.0019

Table 27.1 active portfolio

management with 6 assets
Sp =

E(Rp )

( wM* + w*A A ) E ( RM ) + w*A A

( wM* + w*A A ) 2 M2 + w*A ( e A )

S&P 500 Active Pf A

HP
2

(e)
2

0.5505 / (e)
1.0000 W0 (i)

[W0 (i)]
A

DELL

WMT

TARGET

BP

SHELL

0.0705

0.0572

0.0309

0.0392

0.0297

0.0317

0.2126

-0.1748

-0.1619

0.1911

0.4045

0.0789

0.3863

-0.3176

-0.2941

0.3472

0.7349

0.1433

0.1492

0.1009

0.0865

0.1205

0.5400

0.0205

0.0663

-0.0546

-0.0505

0.0596

0.1262

0.0246

0.0663
0.0750
0.3817

-0.0546
0.1121
0.2901

-0.0505
0.0689
0.1935

0.0596
0.0447
0.2611

0.1262
0.0880
0.1822

0.0246
0.0305
0.1988

0.0222

(eA)

0.0404

W0
W*
Beta
Risk premium
SD
Sharpe Ratio
M-Square

0.1691
0.8282
1
0.06
0.1358
0.44
0

Overall
0.1718 Portfolio
1.0922
0.0878
0.2497
0.35
-0.0123

1.0158
0.0648
0.1422
0.4556
0.0019

Table 27.1 active portfolio

management with 6 assets
S&P 500 Active Pf A

HP
2

(e)
2

0.5505 / (e)
1.0000 W0 (i)

[W0 (i)]
A

DELL

WMT

TARGET

BP

SHELL

0.0705

0.0572

0.0309

0.0392

0.0297

0.0317

0.2126

-0.1748

-0.1619

0.1911

0.4045

0.0789

0.3863

-0.3176

-0.2941

0.3472

0.7349

0.1433

0.1492

0.1009

0.0865

0.1205

0.5400

0.0205

0.0663

-0.0546

-0.0505

0.0596

0.1262

0.0246

0.0663
0.0750
0.3817

-0.0546
0.1121
0.2901

-0.0505
0.0689
0.1935

0.0596
0.0447
0.2611

0.1262
0.0880
0.1822

0.0246
0.0305
0.1988

0.0222

(eA)

0.0404

W0
W*
Beta
Risk premium
SD
Sharpe Ratio
M-Square

0.1691
0.8282
1
0.06
0.1358
0.44
0

Overall
0.1718 Portfolio
1.0922
0.0878
0.2497
0.35
-0.0123

1.0158
0.0648
0.1422
0.4556
0.0019

M Measure
Developed

by Modigliani and Modigliani

Create an adjusted portfolio P* with T-bills
and the managed portfolio P so that
SD[r(P*)]= SD[r(M)]
Example:
Volatility of r(P)=1.5*volatility of r(M)
P*=2/3P+1/3T

With

the same SD, you can now compare the

performance

M = rP* rM
2

M Measure: Example
Managed Portfolio: return = 35%

standard deviation = 42%

Market Portfolio: return = 28%

T-bill return = 6%

standard deviation = 30%

Hypothetical Portfolio:
30/42 = .714 in P
(1-.714) or .286 in T-bills
r(P*)=(.714) (.35) + (.286) (.06) = 26.7%
Since this return is less than the market, the managed portfolio
underperformed

M Measure: Example
E(r)
M
M2

P
P*

T
(M)

(P)

M Measure: Example
E(r)

P*

M2
P

T
(P)

(M)

M Measure
Simplification

for calculation

M 2 = rP* rM
M
wP =
P

M
wT = 1
P

M rP + P rf M rf
rP* =
P

M
rP* =
P

M
rP + 1

rf

rP* = M S P + rf

M 2 = M S P (rM r f ) = M ( S P S M )

Table 27.1 active portfolio

management with 6 assets
S&P 500 Active Pf A

HP
2

(e)
2

0.5505 / (e)
1.0000 W0 (i)

[W0 (i)]
A

DELL

WMT

TARGET

BP

SHELL

0.0705

0.0572

0.0309

0.0392

0.0297

0.0317

0.2126

-0.1748

-0.1619

0.1911

0.4045

0.0789

0.3863

-0.3176

-0.2941

0.3472

0.7349

0.1433

0.1492

0.1009

0.0865

0.1205

0.5400

0.0205

0.0663

-0.0546

-0.0505

0.0596

0.1262

0.0246

0.0663
0.0750
0.3817

-0.0546
0.1121
0.2901

-0.0505
0.0689
0.1935

0.0596
0.0447
0.2611

0.1262
0.0880
0.1822

0.0246
0.0305
0.1988

0.0222

(eA)

0.0404

W0
W*
Beta
Risk premium
SD
Sharpe Ratio
M-Square

0.1691
0.8282
1
0.06
0.1358
0.44
0

Overall
0.1718 Portfolio
1.0922
0.0878
0.2497
0.35
-0.0123

1.0158
0.0648
0.1422
0.4556
0.0019

Target price and alpha on June 1, 2006

The Optimal Risky Portfolio with the

Analysts New Forecasts

The Optimal Risky Portfolio (WA < 1)

Drawback of the model

Extreme

sensitivity to expected return

assumptions
The results often run against investor
intuition
Such quantitative optimization processes
are rarely employed by managers
What about putting some constraints to
this model?

Tracking error
Portfolios

are often compared against a

benchmark
Tracking error TE = RP RM
RP = w*A a A + [1 w*A (1 A )]RM + w*Ae A

TE = w*A a A w*A (1 A ) RM + w*Ae A

Benchmark

Risk: SD of Tracking error

Var (TE ) = [ w*A (1 A )]2 M2 + [ w*A (e A )]2

(TE ) = w*A (1 A ) 2 M2 + 2 (e A )

The Optimal Risky Portfolio with the

Analysts New Forecasts

(TE ) = w*A (1 A ) 2 M2 + 2 (e A )

Tracking error

Set weight in the active portfolio to meet the desired

benchmark risk
For a unit investment in the active portfolio
(TE ; w*A = 1) = (1 A )]2 M + 2 (e A )
For our example:
(TE ; w*A = 1) = 0.0885
For a desired benchmark risk 0 (TE )
0 (TE )
wA (TE ) =
(TE ; w*A = 1)
Assume that the desired benchmark risk is 0.0385

Wa(Te)=0.0385/0.0885
Wa(Te)=0.43

Constrained benchmark risk