Reading 69: The Theory of Active Portfolio Management-LOS b center, returns, security, face, 2011

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Session 18: Portfolio Management: Capital Market Theory and the Portfolio Management Process
Reading 69: The Theory of Active Portfolio Management

LOS b: Discuss the steps and the approach of the Treynor-Black model for security selection.

 

 

An asset’s alpha returns are returns earned in addition to the asset’s:

A) ex ante returns.

B) projected returns.

C) required returns.

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Alpha returns are returns beyond the required return expected on an asset given its level of risk.

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Expected returns beyond required returns are referred to as an asset’s:

A) beta.

B) alpha.

C) ex ante returns.

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Alpha returns are returns beyond the required return expected on an asset given its level of risk.

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Rosemary Stone, CFA, uses the Treynor-Black active portfolio optimization model. Stone attempts to quantify the importance of security selection in the model. Stone should conclude that security selection is of high importance if the actively managed portfolio is characterized by:

Alpha

Unsystematic risk

A) Large Small

B) Large Large

C) Small Large

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The Treynor-Black portfolio optimization model assigns greater weight to the actively managed portfolio if its alpha is large relative to its unsystematic risk. As more weight is given to the actively managed portfolio, more importance is placed on active security selection (from which the actively managed portfolio is created).

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MPT Associates selects optimal portfolios using the Treynor-Black model. Randall Morgan and Charles Alverson, research associates at MPT, debate the assumptions of the model. Morgan states that the model assumes that large numbers of assets are mispriced. Alverson states that the model places high importance on diversification.

Regarding these statements:

A) only Alverson is incorrect.

B) both are incorrect.

C) only Morgan is incorrect.

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The Treynor-Black model combines modern portfolio theory and market inefficiency. The model is based on the premise that markets are nearly efficient, implying that the number of mispriced assets is small. Therefore, Morgan’s statement is not correct. In contrast, Alverson’s statement is correct. The Treynor-Black model incorporates active security selection within an optimally diversified portfolio context. Therefore, the model places large value on the importance of diversification.

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Amanda Keene, CFA, works for an investment firm that employs the Treynor-Black portfolio optimization model. Keene predicts that the market index return will move higher next year as markets move closer to equilibrium. Keene advises a client, whose risk aversion will remain unchanged next year. Using the Treynor-Black framework, Keene should make which of the following changes in her client’s allocations, with respect to the percentage of actively managed and passively managed portfolios, noting that the remaining percentage is allocated to cash?

A) Decrease only actively managed portfolios.

B) Decrease both portfolios.

C) Decrease only passively managed portfolios.

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The client’s risk aversion will remain unchanged next year, which suggests that the percentage allocated to cash will not change. A higher market return suggests greater weight should be placed on the passively managed portfolio, especially in light of Keene’s prediction that markets will move closer to equilibrium. Less emphasis is placed on active management as markets move toward equilibrium (alphas move closer to zero).