Bodie Investments 12e IM CH27

CHAPTER TWENTY-SEVEN
THE THEORY OF ACTIVE PORTFOLIO MANAGEMENT
CHAPTER OVERVIEW
This chapter discusses the theory of active portfolio management. The chapter develops a theoretical
approach to optimization of active managed portfolios.
LEARNING OBJECTIVES
After studying this chapter the student should be able to understand the Treynor-Black Model of efficient
security analysis and be able to describe how it is implemented. The student should also be able to apply
the Black-Litterman Model which allows the incorporation of forecasts or views into the process of
portfolio construction.
PRESENTATION OF CHAPTER MATERIAL

27.1 Optimal Portfolios and Alpha Values
The chapter covers two theoretical models to incorporate active management—first, the Treynor-Black
Model that was originally presented in Chapter 8. Table 27.1 summarizes the steps in this optimization,
commonly known as the Treynor-Black model. The second, the Black-Litterman Model is discussed later
in the chapter.
Using Spreadsheet 27.1 the authors apply the Treynor-Model and finds that combining active and passive
portfolio improves performance over the passive portfolio, but only modestly. The approach is applied to
six securities using analysts’ estimates of alpha which are much larger than the actual measured alphas.
Table 27.2 shows the optimal portfolio using the forecasts discussed in the text rather than the original
alpha values shown in Panel C in Spreadsheet 27.1. With no restrictions on short sales, the optimal mix
calls for a weighting of 579% of funds in active portfolio which is not realistic. No manager would be
willing to accept that level of risk. Table 27.3 shows the optimal portfolio with a standard deviation of
15.38%. With the short sale option removed, the new allocation is displayed in Table 27.4. It shows
about 76% of the portfolio would be in the six active stocks. There is clearly too little diversification.
One of the ways that managers are evaluated is benchmark error. The tracking error from the benchmark
is over 50% when not constrained but using the approach suggested by Black and Litterman reduces that
error significantly. Figure 27.1 illustrates reduced efficiency when benchmark risk is lowered.
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
27.2 The Treynor-Black Model and Forecast Precision
The next section of the text presents the Treynor-Black Model with adjustments for accuracy of forecasts.
Optimization of the risky portfolio entails a number of tasks in terms of expertise and the need for
independence. A discussion on the distribution of alpha values includes Figure 27.2 which represents a
histogram of alpha forecast. Next, Figure 27.3 shows an organizational chart designed to achieve the
goals for portfolio management.
27.3 The Black-Litterman Model

 Application of the Black-Litterman (BL) Model is presented in this section that includes a
discussion on asset allocation and baseline forecasts. The text discusses the model’s steps with
application results. Point out to the students that the Black-Litterman Model will result in the
same allocations (with identical inputs) as the Treynor-Black Model, as discussed in the next
section.
 Step 1: the covariance matrix from historical data.

 Step 2: Determination of a baseline forecast.
 Step 3: Integrating the manager’s private views. Example 27.1 provides an opportunity to explore
the views in the Black-Litterman model.
 Step 4: Revised (posterior) expectations.
 Step 5: Portfolio Optimization. Spreadsheet 27.2 presents the calculations of the BL model.
Figure 27.4 shows portfolio performance measured by M-square for various levels of confidence
in the view when the view is correct and incorrect.
27.4 Treynor-Black Versus Black-Litterman: Complements, not Substitutes
The Treynor-Black (TB) Model is really oriented to individual security analysis. This can be seen from
the way the active portfolio is constructed. The alpha values assigned to securities must be determined
relative to the passive portfolio. Now suppose an investment company invested in both a U.S. universe of
large stocks and in a well-defined universe of large European stocks. In that case, the macro analysis of
the organization would have to be split, and the TB Model would have to be run as two separate divisions.
The resulting portfolio could be improved using the BL approach. First, views about the relative
performance of the U.S. and European markets can be expected to add information to the independent
macro forecasts for the two economies.
27.5 The Value of Active Management
The results show that even with small forecast accuracy the techniques discussed in this chapter can
greatly improve performance. The results also provide some justification for fees: (1) the coefficient of
risk aversion, (2) the distribution of the squared information ratio in the universe of securities, and (3) the
precision of the security analysts.
27.6 Concluding Remarks on Active Management

The chapter concludes with a discussion of why theory should be applied to portfolio construction. It
makes the argument that the distance between theory and practice has narrowed in recent years and the
CFA is expanding the industry knowledge base.
Excel Models
Excel models that cover material in this chapter are available on the Online Learning Center
(www.mhhe.com/bkm).

Bodie Investments 12e IM CH27

Uploaded by

Copyright:

Available Formats

Bodie Investments 12e IM CH27

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Bodie Investments 12e IM CH27

Uploaded by

Copyright:

Available Formats

CHAPTER TWENTY-SEVEN

THE THEORY OF ACTIVE PORTFOLIO MANAGEMENT

PRESENTATION OF CHAPTER MATERIAL

27.3 The Black-Litterman Model

 Step 1: the covariance matrix from historical data.

27.6 Concluding Remarks on Active Management

You might also like