The Treynor-Black Model

• Treynor and Black developed a portfolio optimization model that seeks to maximize a portfolio's Sharpe Ratio through a combination of an actively managed portfolio component built with a few select mispriced securities and a passively managed market index portfolio component.
• Treynor-Black assumes that markets are highly, but no perfectly efficient.
• Macroeconomic forecasting can be applied to calculate the expected return and standard deviation of the portfolio.
• Securities can be assessed for mispricing by comparing the forecasted return with the required return based on the Security Market Line.
• Mispricing presents the opportunity for abnormal return, where abnormal return is the analyst's expected return minus the required return dictated by the Security Market Line.
• The cost of less than full market diversification is reflected by the variance of the residual error of the active securities.

Treynor-Black Process

• Economists create forecasts to derive inputs for the security representing the market portfolio.

• Security analysts isolate the few securities mispriced by the market.

• The portfolio manager constructs the optimal portfolio.

• Post investment period quality analysis can be done by:

• Measuring the correlation squared of the security analyst's forecasted alphas to actual alphas realized.

• A high correlation will give the portfolio manager confidence in the analysts' abilities to correctly identify mispriced securities in the future.

Limitations of Treynor-Black for Investors

• Some investors may prohibit their portfolio managers from short selling, which limits the ability to exploit overpriced assets.
• Treynor-Black relies on successfully forecasting alpha, which is incredibly difficult for even well trained analysts.