Chapter 27

The Theory of Active Portfolio Management

 

Multiple Choice Questions

 

1. In the Treynor-Black model 

 

A. portfolio weights are sensitive to large alpha values which can lead to infeasible long or short positions
for many portfolio managers.
B. portfolio weights are not sensitive to large alpha values which can lead to infeasible long or short
positions for many portfolio managers.
C.  portfolio weights are sensitive to large alpha values which can lead to the optimal portfolio for most
portfolio managers.
D. portfolio weights are not sensitive to large alpha values which can lead to the optimal portfolio for most
portfolio managers.
 
2. Absent research, you should assume the alpha of a stock is 
 

A. zero.
B. positive.
C.  negative.
D. not zero.
E.  zero or positive.
 
3. If you begin with a ______ and obtain additional data from an experiment you can form a ______. 
 

A. posterior distribution; prior distribution

B. prior distribution; posterior distribution
C.  tight posterior; Bayesian analysis
D. tight prior; Bayesian analysis
E.  None of the options
 

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4. Benchmark risk is defined as 
 

A. the return difference between the portfolio and the benchmark.

B. the standard deviation of the return of the benchmark portfolio.
C.  the standard deviation of the return difference between the portfolio and the benchmark.
D. the standard deviation of the return of the actively managed portfolio.
 
5. Benchmark risk 
 

A. is inevitable and is never a significant issue in practice.

B. is inevitable and is always a significant issue in practice.
C.  cannot be constrained to keep a Treynor-Black portfolio within reasonable weights.
D. can be constrained to keep a Treynor-Black portfolio within reasonable weights.
 
6. ____________ can be used to measure forecast quality and guide in the proper adjustment of forecasts. 
 

A. Regression analysis
B. Exponential smoothing
C.  ARIM
A
D. Moving average models
E.  GAUSS
 
7. Even low-quality forecasts have proven to be valuable because R-squares of only ____________ in
regressions of analysts' forecasts can be used to substantially improve portfolio performance. 
 

A. 0.656
B. 0.452
C.  0.258
D. 0.153
E.  0.001
 
8. The ____________ model allows the private views of the portfolio manager to be incorporated with market
data in the optimization procedure. 
 

A. Black-Litterman
B. Treynor-Black
C.  Treynor-Mazuy
D. Black-Scholes
 

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9. The Black-Litterman model and Treynor-Black model are 
 

A. nice in theory but practically useless in modern portfolio management.

B. complementary tools that should be used in portfolio management.
C.  contradictory models that cannot be used together; therefore, portfolio managers must choose which one
suits their needs.
D. not useful due to their complexity.
E.  None of the options
 
10. The Black-Litterman model is geared toward ____________ while the Treynor-Black model is geared
toward ____________. 
 

A. security analysis; security analysis

B. asset allocation; asset allocation
C.  security analysis; asset allocation
D. asset allocation; security analysis
E.  None of the options
 
11. Alpha forecasts must be ____________ to account for less-than-perfect forecasting quality. When alpha
forecasts are ____________ to account for forecast imprecision, the resulting portfolio position becomes
____________. 
 

A. shrunk; shrunk; far less moderate

B. shrunk; shrunk; far more moderate
C.  grossed up; grossed up; far less moderate
D. grossed up; grossed up; far more moderate
E.  None of the options
 
12. Tracking error is defined as 
 

A. the difference between the returns on the overall risky portfolio versus the benchmark return.
B. the variance of the return of the benchmark portfolio.
C.  the variance of the return difference between the portfolio and the benchmark.
D. the variance of the return of the actively managed portfolio.
 

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13. The tracking error of an optimized portfolio can be expressed in terms of the ____________ of the portfolio
and thus reveals ____________. 
 

A. return; portfolio performance

B. total risk; portfolio performance
C.  beta; portfolio performance
D. beta; benchmark risk
E.  relative return; benchmark risk
 
14. The Treynor-Black model is a model that shows how an investment manager can use security analysis and
statistics to construct 
 

A. a market portfolio.

B. a passive portfolio.
C.  an active portfolio.
D. an index portfolio.
E.  a balanced portfolio.
 
15. If a portfolio manager consistently obtains a high Sharpe measure, the manager's forecasting ability 
 

A. is above average.

B. is average.
C.  is below average.
D. does not exist.
E.  cannot be determined based on the Sharpe measure.
 
16. Active portfolio management consists of 
 

A. market timing.
B. security analysis.
C.  indexing.
D. market timing and security analysis.
E.  None of the options
 

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17. Passive portfolio management consists of 
 

A. market timing.
B. security analysis.
C.  indexing.
D. market timing and security analysis.
E.  None of the options
 
18. The critical variable in the determination of the success of the active portfolio is 
 

A. alpha/systematic risk.
B. alpha/nonsystematic risk.
C.  gamma/systematic risk.
D. gamma/nonsystematic risk.
 
19. The Treynor-Black model requires estimates of 
 

A. alpha/beta.
B. alpha/beta/residual variance.
C.  beta/residual variance.
D. alpha/residual variance.
 
20. Active portfolio managers try to construct a risky portfolio with 
 

A. a higher Sharpe measure than a passive strategy.

B. a lower Sharpe measure than a passive strategy.
C.  the same Sharpe measure as a passive strategy.
D. very few securities.
 
21. The beta of an active portfolio is 1.20. The standard deviation of the returns on the market index is 20%.
The nonsystematic variance of the active portfolio is 1%. The standard deviation of the returns on the
active portfolio is 
 

A. 3.84%.
B. 5.84%.
C.  19.60%.
D. 24.17%.
E.  26.0%.
 

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22. The beta of an active portfolio is 1.36. The standard deviation of the returns on the market index is 22%.
The nonsystematic variance of the active portfolio is 1.2%. The standard deviation of the returns on the
active portfolio is 
 

A. 3.19%.
B. 31.86%.
C.  42.00%.
D. 27.57%.
E.  2.86%.
 
23. Consider the Treynor-Black model. The alpha of an active portfolio is 2%. The expected return on the
market index is 16%. The variance of return on the market portfolio is 4%. The nonsystematic variance of
the active portfolio is 1%. The risk-free rate of return is 8%. The beta of the active portfolio is 1. The
optimal proportion to invest in the active portfolio is 
 

A. 0%.
B. 25%.
C.  50%.
D. 100%.
 
24. Consider the Treynor-Black model. The alpha of an active portfolio is 1%. The expected return on the
market index is 16%. The variance of the return on the market portfolio is 4%. The nonsystematic variance
of the active portfolio is 1%. The risk-free rate of return is 8%. The beta of the active portfolio is 1.05. The
optimal proportion to invest in the active portfolio is 
 

A. 48.7%.
B. 50.0%.
C.  51.3%.
D. 100.0%.
 

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25. There appears to be a role for a theory of active portfolio management because 
 

A. some portfolio managers have produced sequences of abnormal returns that are difficult to label as lucky
outcomes.
B. the "noise" in the realized returns is enough to prevent the rejection of the hypothesis that some money
managers have outperformed a passive strategy by a statistically small, yet economic, margin.
C.  some anomalies in realized returns have been persistent enough to suggest that portfolio managers who
identified these anomalies in a timely fashion could have outperformed a passive strategy over
prolonged periods.
D. some portfolio managers have produced sequences of abnormal returns that are difficult to label as
lucky outcomes and the "noise" in the realized returns is enough to prevent the rejection of the
hypothesis that some money managers have outperformed a passive strategy by a statistically small, yet
economic, margin.
E.  All of the options
 
26. The Treynor-Black model 
 

A. considers both macroeconomic and microeconomic risks.

B. considers security selection only.
C.  is nearly impossible to implement.
D. considers both macroeconomic and microeconomic risks and is nearly impossible to implement.
E.  considers security selection only and is nearly impossible to implement.
 
27. Which of the following are not true regarding the Treynor-Black model? 
 

A. It considers both macroeconomic and microeconomic risks.

B. It considers security selection only.
C.  It is nearly impossible to implement.
D. It considers both macroeconomic and microeconomic risks, and it is nearly impossible to implement.
E.  It considers security selection only, and it is nearly impossible to implement.
 
28. To improve future analyst forecasts using the statistical properties of past forecasts, a regression model can
be fitted to past forecasts. The intercept of the regression is a __________ coefficient, and the regression
beta represents a __________ coefficient. 
 

A. bias; precision
B. bias; bias
C.  precision; precision
D. precision; bias
 

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29. A purely passive strategy is defined as 
 

A. one that uses only index funds.

B. one that allocates assets in fixed proportions that do not vary with market conditions.
C.  one that is mean-variance efficient.
D. one that uses only index funds and allocates assets in fixed proportions that do not vary with market
conditions.
E.  All of the options
 
30. Consider these two investment strategies:

   

Strategy __________ is the dominant strategy because __________. 

 

A. 1; it is riskless
B. 1; it has the highest reward/risk ratio
C.  2; its return is at least equal to Strategy 1 and sometimes greater
D. 2; it has the highest reward/risk ratio
E.  Both strategies are equally preferred.
 
31. Consider these two investment strategies:

   

Strategy __________ is the dominant strategy because __________. 

 

A. 1; it is riskless
B. 1; it has the highest reward/risk ratio
C.  2; its return is at least equal to Strategy 1 and sometimes greater
D. 2; it has the highest reward/risk ratio
E.  Both strategies are equally preferred.
 

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32. The Treynor-Black model assumes that 
 

A. the objective of security analysis is to form an active portfolio of a limited number of mispriced
securities.
B. the cost of less than full diversification comes from the nonsystematic risk of the mispriced stock.
C.  the optimal weight of a mispriced security in the active portfolio is a function of the degree of
mispricing, the market sensitivity of the security, and its degree of nonsystematic risk.
D. All of the options
E.  None of the options
 
33. The Treynor-Black model does not assume that 
 

A. the objective of security analysis is to form an active portfolio of a limited number of mispriced
securities.
B. the cost of less than full diversification comes from the nonsystematic risk of the mispriced stock.
C.  the optimal weight of a mispriced security in the active portfolio is a function of the degree of
mispricing, the market sensitivity of the security, and its degree of nonsystematic risk.
D. indexing is always optimal.
 
34. Consider the Treynor-Black model. The alpha of an active portfolio is 3%. The expected return on the
market index is 18%. The standard deviation of the return on the market portfolio is 25%. The
nonsystematic standard deviation of the active portfolio is 15%. The risk-free rate of return is 6%. The beta
of the active portfolio is 1.2. The optimal proportion to invest in the active portfolio is 
 

A. 50.0%.
B. 69.4%.
C.  72.3%.
D. 80.6%.
E.  100.0%.
 
35. According to the Treynor-Black model, the weight of a security in the active portfolio depends on the ratio
of __________ to __________. 
 

A. the degree of mispricing; the nonsystematic risk of the security

B. the degree of mispricing; the systematic risk of the security
C.  the market sensitivity of the security; the nonsystematic risk of the security
D. the nonsystematic risk of the security; the systematic risk of the security
E.  the total return on the security; the nonsystematic risk of the security
 

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36. One property of a risky portfolio that combines an active portfolio of mispriced securities with a market
portfolio is that, when optimized, its squared Sharpe measure increases by the square of the active
portfolio's 
 

A. Sharpe ratio.
B. information ratio.
C.  alpha.
D. Treynor measure.
E.  None of the options
 
37. A purely passive strategy 
 

A. uses only index funds.

B. uses weights that change in response to market conditions.
C.  uses only risk-free assets.
D. is best if there is "noise" in realized returns.
E.  is useless if abnormal returns are available.
 
38. A manager who uses the mean-variance theory to construct an optimal portfolio will satisfy 
 

A. investors with low risk-aversion coefficients.

B. investors with high risk-aversion coefficients.
C.  investors with moderate risk-aversion coefficients.
D. all investors, regardless of their level of risk aversion.
E.  only clients with whom she has established long-term relationships, because she knows their personal
preferences.
 
39. Ideally, clients would like to invest with the portfolio manager who has 
 

A. a moderate personal risk-aversion coefficient.

B. a low personal risk-aversion coefficient.
C.  the highest Sharpe measure.
D. the highest record of realized returns.
E.  the lowest record of standard deviations.
 

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40. An active portfolio manager faces a trade-off between

I) using the Sharpe measure.

II) using mean-variance analysis.
III) exploiting perceived security mispricings.
IV) holding too much of the risk-free asset.
V) letting a few stocks dominate the portfolio. 
 

A. I and II
B. II and V
C.  III and V
D. III and IV
E.  II and III
 
41. To determine the optimal risky portfolio in the Treynor-Black model, macroeconomic forecasts are used for
the _________ and composite forecasts are used for the __________. 
 

A. passive index portfolio; active portfolio

B. active portfolio, passive index portfolio
C.  expected return; standard deviation
D. expected return ; beta coefficient
E.  alpha coefficient; beta coefficient
 
42. The beta of an active portfolio is 1.45. The standard deviation of the returns on the market index is 22%.
The nonsystematic variance of the active portfolio is 3%. The standard deviation of the returns on the
active portfolio is 
 

A. 36.30%.
B. 5.84%.
C.  19.60%.
D. 24.17%.
E.  26.0%.
 

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43. Consider the Treynor-Black model. The alpha of an active portfolio is 1%. The expected return on the
market index is 11%. The variance of return on the market portfolio is 6%. The nonsystematic variance of
the active portfolio is 2%. The risk-free rate of return is 4%. The beta of the active portfolio is 1.1. The
optimal proportion to invest in the active portfolio is 
 

A. 45%.
B. 25%.
C.  50%.
D. 100%.
 
44. Consider the Treynor-Black model. The alpha of an active portfolio is 3%. The expected return on the
market index is 10%. The variance of the return on the market portfolio is 4%. The nonsystematic variance
of the active portfolio is 2%. The risk-free rate of return is 3%. The beta of the active portfolio is 1.15. The
optimal proportion to invest in the active portfolio is 
 

A. 48.7%.
B. 98.4%.
C.  51.3%.
D. 100.0%.
 
45. Consider the Treynor-Black model. The alpha of an active portfolio is 2%. The expected return on the
market index is 12%. The variance of the return on the market portfolio is 4%. The nonsystematic variance
of the active portfolio is 2%. The risk-free rate of return is 3%. The beta of the active portfolio is 1.15. The
optimal proportion to invest in the active portfolio is 
 

A. 48.7%.
B. 98.3%.
C.  47.6%.
D. 100.0%.
 
46. Perfect timing ability is equivalent to having __________ on the market portfolio. 
 

A. a call option

B. a futures contract
C.  a put option
D. a commodities contract
 

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47. Kane, Marcus, and Trippi (1999) show that the annualized fee that investors should be willing to pay for
active management, over and above the fee charged by a passive index fund, depends on

I) the investor's coefficient of risk aversion.

II) the value of at-the-money call option on the market portfolio.
III) the value of out-of-the-money call option on the market portfolio.
IV) the precision of the security analyst.
V) the distribution of the squared information ratio of in the universe of securities. 
 

A. I, II, and IV

B. I, III, and V
C.  II, IV, and V
D. I, IV, and V
E.  II, III, and V
 
48. Kane, Marcus, and Trippi (1999) show that the annualized fee that investors should be willing to pay for
active management, over and above the fee charged by a passive index fund, does not depend on

I) the investor's coefficient of risk aversion.

II) the value of at-the-money call option on the market portfolio.
III) the value of out-of-the-money call option on the market portfolio.
IV) the precision of the security analyst.
V) the distribution of the squared information ratio of in the universe of securities. 
 

A. I, II, and IV

B. II, III, and V
C.  II and III
D. I, IV, and V
E.  II, IV, and V
 
 

Short Answer Questions

 

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49. Discuss the Treynor-Black model. 
 

 
50. You have a record of an analyst's past forecasts of alpha. Describe how you would use this information
within the context of the Treynor-Black model to determine the forecasting ability of the analyst. 
 

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 Chapter 27 The Theory of Active Portfolio Management Answer Key
 
 

Multiple Choice Questions

 

1. In the Treynor-Black model 

 

A.  portfolio weights are sensitive to large alpha values which can lead to infeasible long or short
positions for many portfolio managers.
B.  portfolio weights are not sensitive to large alpha values which can lead to infeasible long or short
positions for many portfolio managers.
C.  portfolio weights are sensitive to large alpha values which can lead to the optimal portfolio for most
portfolio managers.
D.  portfolio weights are not sensitive to large alpha values which can lead to the optimal portfolio for
most portfolio managers.

In the Treynor-Black model portfolio weight are sensitive to large alpha values which can lead to
infeasible long or short positions for many portfolio managers.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 
2. Absent research, you should assume the alpha of a stock is 
 

A.  zero.
B.  positive.
C.  negative.
D.  not zero.
E.  zero or positive.

In efficient markets, alpha should be assumed to be zero.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 

27-15
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3. If you begin with a ______ and obtain additional data from an experiment you can form a ______. 
 

A.  posterior distribution; prior distribution

B.  prior distribution; posterior distribution
C.  tight posterior; Bayesian analysis
D.  tight prior; Bayesian analysis
E.  None of the options

If you begin with a prior distribution and obtain additional data from an experiment you can form a
posterior distribution.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 
4. Benchmark risk is defined as 
 

A.  the return difference between the portfolio and the benchmark.
B.  the standard deviation of the return of the benchmark portfolio.
C.  the standard deviation of the return difference between the portfolio and the benchmark.
D.  the standard deviation of the return of the actively managed portfolio.

Benchmark portfolio risk is defined as the standard deviation of the return difference between the
portfolio and the benchmark.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 
5. Benchmark risk 
 

A.  is inevitable and is never a significant issue in practice.

B.  is inevitable and is always a significant issue in practice.
C.  cannot be constrained to keep a Treynor-Black portfolio within reasonable weights.
D.  can be constrained to keep a Treynor-Black portfolio within reasonable weights.

Benchmark portfolio risk can be constrained to keep a Treynor-Black portfolio within reasonable
weights.

 
AACSB: Analytic
Blooms: Remember

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 Difficulty: Intermediate
Topic: Active Management
 
6. ____________ can be used to measure forecast quality and guide in the proper adjustment of forecasts. 
 

A.  Regression analysis

B.  Exponential smoothing
C.  ARIM
A
D.  Moving average models
E.  GAUSS

Regression analysis can be used to measure forecast quality and guide in the proper adjustment of
forecasts.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 
7. Even low-quality forecasts have proven to be valuable because R-squares of only ____________ in
regressions of analysts' forecasts can be used to substantially improve portfolio performance. 
 

A.  0.656
B.  0.452
C.  0.258
D.  0.153
E.  0.001

The text provides an example where forecasts improved as r-squared improved from 0.001134 to
0.001536.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 

27-17
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8. The ____________ model allows the private views of the portfolio manager to be incorporated with
market data in the optimization procedure. 
 

A.  Black-Litterman
B.  Treynor-Black
C.  Treynor-Mazuy
D.  Black-Scholes

The Black-Litterman model allows the private views of the portfolio manager to be incorporated with
market data in the optimization procedure.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 
9. The Black-Litterman model and Treynor-Black model are 
 

A.  nice in theory but practically useless in modern portfolio management.

B.  complementary tools that should be used in portfolio management.
C.  contradictory models that cannot be used together; therefore, portfolio managers must choose which
one suits their needs.
D.  not useful due to their complexity.
E.  None of the options

The Black-Litterman model and Treynor-Black model are complementary tools that should be used in
portfolio management.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 

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10. The Black-Litterman model is geared toward ____________ while the Treynor-Black model is geared
toward ____________. 
 

A.  security analysis; security analysis

B.  asset allocation; asset allocation
C.  security analysis; asset allocation
D.  asset allocation; security analysis
E.  None of the options

The Black-Litterman model is geared toward asset allocation while the Treynor-Black model is geared
toward security analysis.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 
11. Alpha forecasts must be ____________ to account for less-than-perfect forecasting quality. When alpha
forecasts are ____________ to account for forecast imprecision, the resulting portfolio position
becomes ____________. 
 

A.  shrunk; shrunk; far less moderate

B.  shrunk; shrunk; far more moderate
C.  grossed up; grossed up; far less moderate
D.  grossed up; grossed up; far more moderate
E.  None of the options

Alpha forecasts must be shrunk to account for less-than-perfect forecasting quality. When alpha
forecasts are shrunk to account for forecast imprecision, the resulting portfolio position becomes far
more moderate.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 

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12. Tracking error is defined as 
 

A.  the difference between the returns on the overall risky portfolio versus the benchmark return.
B.  the variance of the return of the benchmark portfolio.
C.  the variance of the return difference between the portfolio and the benchmark.
D.  the variance of the return of the actively managed portfolio.

Tracking error is defined as the difference between the returns on the overall risky portfolio versus the
benchmark return.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 
13. The tracking error of an optimized portfolio can be expressed in terms of the ____________ of the
portfolio and thus reveals ____________. 
 

A.  return; portfolio performance

B.  total risk; portfolio performance
C.  beta; portfolio performance
D.  beta; benchmark risk
E.  relative return; benchmark risk

The tracking error of an optimized portfolio can be expressed in terms of the beta of the portfolio and
thus reveals benchmark risk.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 

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14. The Treynor-Black model is a model that shows how an investment manager can use security analysis
and statistics to construct 
 

A.  a market portfolio.

B.  a passive portfolio.
C.  an active portfolio.
D.  an index portfolio.
E.  a balanced portfolio.

The Treynor-Black model is a model that shows how an investment manager can use security analysis
and statistics to construct an active portfolio.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Basic
Topic: Active Management
 
15. If a portfolio manager consistently obtains a high Sharpe measure, the manager's forecasting ability 
 

A.  is above average.

B.  is average.
C.  is below average.
D.  does not exist.
E.  cannot be determined based on the Sharpe measure.

The manager with the highest Sharpe measure presumably has true forecasting abilities.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Basic
Topic: Active Management
 

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16. Active portfolio management consists of 
 

A.  market timing.

B.  security analysis.
C.  indexing.
D.  market timing and security analysis.
E.  None of the options

Although one can engage in various degrees of active portfolio management (security selection without
market timing and vice versa), the most active portfolio management strategy consists of engaging in
both pursuits.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Basic
Topic: Active Management
 
17. Passive portfolio management consists of 
 

A.  market timing.

B.  security analysis.
C.  indexing.
D.  market timing and security analysis.
E.  None of the options

Although one can engage in various degrees of active portfolio management (security selection without
market timing and vice versa), the most active portfolio management strategy consists of engaging in
both pursuits. Passive management is an indexing strategy.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Basic
Topic: Active Management
 

27-22
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18. The critical variable in the determination of the success of the active portfolio is 
 

A.  alpha/systematic risk.

B.  alpha/nonsystematic risk.
C.  gamma/systematic risk.
D.  gamma/nonsystematic risk.

A portfolio with a positive alpha is outperforming the market. If this portfolio also has a low degree of
nonsystematic risk, the portfolio is adequately diversified.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 
19. The Treynor-Black model requires estimates of 
 

A.  alpha/beta.
B.  alpha/beta/residual variance.
C.  beta/residual variance.
D.  alpha/residual variance.

Estimates of alpha, beta, and residual risk are required to determine the optimal weight of each security
in the portfolio.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 
20. Active portfolio managers try to construct a risky portfolio with 
 

A.  a higher Sharpe measure than a passive strategy.

B.  a lower Sharpe measure than a passive strategy.
C.  the same Sharpe measure as a passive strategy.
D.  very few securities.

A higher Sharpe measure than a passive strategy is indicative of the benefits of active management.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 

27-23
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McGraw-Hill Education.
21. The beta of an active portfolio is 1.20. The standard deviation of the returns on the market index is 20%.
The nonsystematic variance of the active portfolio is 1%. The standard deviation of the returns on the
active portfolio is 
 

A.  3.84%.
B.  5.84%.
C.  19.60%.
D.  24.17%.
E.  26.0%.

s = [(1.2)2(0.2)2 + 0.01]1/2 = [0.0676]1/2 = 26.0%.

 
AACSB: Analytic
Blooms: Apply
Difficulty: Challenge
Topic: Active Management
 
22. The beta of an active portfolio is 1.36. The standard deviation of the returns on the market index is 22%.
The nonsystematic variance of the active portfolio is 1.2%. The standard deviation of the returns on the
active portfolio is 
 

A.  3.19%.
B.  31.86%.
C.  42.00%.
D.  27.57%.
E.  2.86%.

s = [(1.36)2(0.22)2 + 0.012]1/2 = [0.10152]1/2 = 31.86%.

 
AACSB: Analytic
Blooms: Apply
Difficulty: Challenge
Topic: Active Management
 

27-24
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23. Consider the Treynor-Black model. The alpha of an active portfolio is 2%. The expected return on the
market index is 16%. The variance of return on the market portfolio is 4%. The nonsystematic variance
of the active portfolio is 1%. The risk-free rate of return is 8%. The beta of the active portfolio is 1. The
optimal proportion to invest in the active portfolio is 
 

A.  0%.
B.  25%.
C.  50%.
D.  100%.

wO = [2%/1%]/[(16% - 8%)/4%] = 1, or 100%; w* = 1/[1 + (1 - 1)1] = 1.

 
AACSB: Analytic
Blooms: Apply
Difficulty: Challenge
Topic: Active Management
 
24. Consider the Treynor-Black model. The alpha of an active portfolio is 1%. The expected return on the
market index is 16%. The variance of the return on the market portfolio is 4%. The nonsystematic
variance of the active portfolio is 1%. The risk-free rate of return is 8%. The beta of the active portfolio
is 1.05. The optimal proportion to invest in the active portfolio is 
 

A.  48.7%.
B.  50.0%.
C.  51.3%.
D.  100.0%.

wO = [1%/1%]/[(16% - 8%)/4%] = 0.5; w* = 0.5/[1 + (1 - 1.05)0.5] = 0.513, or 51.3%.

 
AACSB: Analytic
Blooms: Apply
Difficulty: Challenge
Topic: Active Management
 

27-25
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McGraw-Hill Education.
25. There appears to be a role for a theory of active portfolio management because 
 

A.  some portfolio managers have produced sequences of abnormal returns that are difficult to label as
lucky outcomes.
B.  the "noise" in the realized returns is enough to prevent the rejection of the hypothesis that some
money managers have outperformed a passive strategy by a statistically small, yet economic,
margin.
C.  some anomalies in realized returns have been persistent enough to suggest that portfolio managers
who identified these anomalies in a timely fashion could have outperformed a passive strategy over
prolonged periods.
D.  some portfolio managers have produced sequences of abnormal returns that are difficult to label as
lucky outcomes and the "noise" in the realized returns is enough to prevent the rejection of the
hypothesis that some money managers have outperformed a passive strategy by a statistically small,
yet economic, margin.
E.  All of the options

All of the statements are true.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Basic
Topic: Active Management
 
26. The Treynor-Black model 
 

A.  considers both macroeconomic and microeconomic risks.

B.  considers security selection only.
C.  is nearly impossible to implement.
D.  considers both macroeconomic and microeconomic risks and is nearly impossible to implement.
E.  considers security selection only and is nearly impossible to implement.

The Treynor-Black model considers both macroeconomic and microeconomic risks.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Basic
Topic: Active Management
 

27-26
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McGraw-Hill Education.
27. Which of the following are not true regarding the Treynor-Black model? 
 

A.  It considers both macroeconomic and microeconomic risks.

B.  It considers security selection only.
C.  It is nearly impossible to implement.
D.  It considers both macroeconomic and microeconomic risks, and it is nearly impossible to
implement.
E.  It considers security selection only, and it is nearly impossible to implement.

The Treynor-Black model considers both macroeconomic and microeconomic risks. Other answers are
false.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Basic
Topic: Active Management
 
28. To improve future analyst forecasts using the statistical properties of past forecasts, a regression model
can be fitted to past forecasts. The intercept of the regression is a __________ coefficient, and the
regression beta represents a __________ coefficient. 
 

A.  bias; precision

B.  bias; bias
C.  precision; precision
D.  precision; bias

The estimated equation adjusts future forecasts for direction and magnitude of bias and degree of
imprecision in past forecasts.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 

27-27
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29. A purely passive strategy is defined as 
 

A.  one that uses only index funds.

B.  one that allocates assets in fixed proportions that do not vary with market conditions.
C.  one that is mean-variance efficient.
D.  one that uses only index funds and allocates assets in fixed proportions that do not vary with market
conditions.
E.  All of the options

A purely passive strategy is one that calls for no market analysis.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Basic
Topic: Active Management
 
30. Consider these two investment strategies:

   

Strategy __________ is the dominant strategy because __________. 

 

A.  1; it is riskless
B.  1; it has the highest reward/risk ratio
C.  2; its return is at least equal to Strategy 1 and sometimes greater
D.  2; it has the highest reward/risk ratio
E.  Both strategies are equally preferred.

Strategy 2 dominates strategy 1, even though it is riskier, because it always returns at least as much as
strategy 1 and sometimes more.

 
AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Topic: Active Management
 

27-28
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McGraw-Hill Education.
31. Consider these two investment strategies:

   

Strategy __________ is the dominant strategy because __________. 

 

A.  1; it is riskless
B.  1; it has the highest reward/risk ratio
C.  2; its return is at least equal to Strategy 1 and sometimes greater
D.  2; it has the highest reward/risk ratio
E.  Both strategies are equally preferred.

Strategy 2 dominates strategy 1, even though it is riskier, because it always returns at least as much as
strategy 1 and sometimes more.

 
AACSB: Analytic
Blooms: Apply
Difficulty: Intermediate
Topic: Active Management
 
32. The Treynor-Black model assumes that 
 

A.  the objective of security analysis is to form an active portfolio of a limited number of mispriced
securities.
B.  the cost of less than full diversification comes from the nonsystematic risk of the mispriced stock.
C.  the optimal weight of a mispriced security in the active portfolio is a function of the degree of
mispricing, the market sensitivity of the security, and its degree of nonsystematic risk.
D.  All of the options
E.  None of the options

All of the statements correctly describe assumptions of the Treynor-Black model.

 
AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Topic: Active Management
 

27-29
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33. The Treynor-Black model does not assume that 
 

A.  the objective of security analysis is to form an active portfolio of a limited number of mispriced
securities.
B.  the cost of less than full diversification comes from the nonsystematic risk of the mispriced stock.
C.  the optimal weight of a mispriced security in the active portfolio is a function of the degree of
mispricing, the market sensitivity of the security, and its degree of nonsystematic risk.
D.  indexing is always optimal.

The other statements correctly describe assumptions of the Treynor-Black model.

 
AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Topic: Active Management
 
34. Consider the Treynor-Black model. The alpha of an active portfolio is 3%. The expected return on the
market index is 18%. The standard deviation of the return on the market portfolio is 25%. The
nonsystematic standard deviation of the active portfolio is 15%. The risk-free rate of return is 6%. The
beta of the active portfolio is 1.2. The optimal proportion to invest in the active portfolio is 
 

A.  50.0%.
B.  69.4%.
C.  72.3%.
D.  80.6%.
E.  100.0%.

wO = [3%/2.25%]/[(18% - 6%)/6.25%] = 0.6944; w* = 0.6944/[1 + (1 - 1.2)0.6944] = 0.8064, or 80.6%.

 
AACSB: Analytic
Blooms: Apply
Difficulty: Challenge
Topic: Active Management
 

27-30
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35. According to the Treynor-Black model, the weight of a security in the active portfolio depends on the
ratio of __________ to __________. 
 

A.  the degree of mispricing; the nonsystematic risk of the security

B.  the degree of mispricing; the systematic risk of the security
C.  the market sensitivity of the security; the nonsystematic risk of the security
D.  the nonsystematic risk of the security; the systematic risk of the security
E.  the total return on the security; the nonsystematic risk of the security

The weight of the mispriced security in the active portfolio depends on the degree of mispricing (alpha)
in proportion to the nonsystematic risk added by holding the security.

 
AACSB: Analytic
Blooms: Understand
Difficulty: Intermediate
Topic: Active Management
 
36. One property of a risky portfolio that combines an active portfolio of mispriced securities with a market
portfolio is that, when optimized, its squared Sharpe measure increases by the square of the active
portfolio's 
 

A.  Sharpe ratio.

B.  information ratio.
C.  alpha.
D.  Treynor measure.
E.  None of the options

When optimized, a property of the overall risky portfolio is that its squared Sharpe measure increases by
the square of the active portfolio's information ratio.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 

27-31
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McGraw-Hill Education.
37. A purely passive strategy 
 

A.  uses only index funds.

B.  uses weights that change in response to market conditions.
C.  uses only risk-free assets.
D.  is best if there is "noise" in realized returns.
E.  is useless if abnormal returns are available.

A purely passive strategy uses only index funds and keeps the proportions constant when there are
changes in perceived market conditions.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 
38. A manager who uses the mean-variance theory to construct an optimal portfolio will satisfy 
 

A.  investors with low risk-aversion coefficients.

B.  investors with high risk-aversion coefficients.
C.  investors with moderate risk-aversion coefficients.
D.  all investors, regardless of their level of risk aversion.
E.  only clients with whom she has established long-term relationships, because she knows their
personal preferences.

The optimal portfolio will be the one with the highest reward-to-variability ratio. Investors can choose
for themselves how they want to combine this portfolio with the risk-free asset to take on more or less
risk.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Basic
Topic: Active Management
 

27-32
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39. Ideally, clients would like to invest with the portfolio manager who has 
 

A.  a moderate personal risk-aversion coefficient.

B.  a low personal risk-aversion coefficient.
C.  the highest Sharpe measure.
D.  the highest record of realized returns.
E.  the lowest record of standard deviations.

The Sharpe measure is commonly used to measure the performance of professional managers. A good
manager has a steeper CAL than the one from following a passive strategy.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Basic
Topic: Active Management
 
40. An active portfolio manager faces a trade-off between

I) using the Sharpe measure.

II) using mean-variance analysis.
III) exploiting perceived security mispricings.
IV) holding too much of the risk-free asset.
V) letting a few stocks dominate the portfolio. 
 

A.  I and II
B.  II and V
C.  III and V
D.  III and IV
E.  II and III

The active manager can use both the Sharpe measure and mean-variance analysis. The risk-free asset
can be included as called for by market conditions. The active manager is seeking out mispricings and
will want to exploit them. If there are a few very attractive securities the manager might have a
concentration of these in the portfolio, which could lead to poor diversification.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Challenge
Topic: Active Management
 

27-33
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McGraw-Hill Education.
41. To determine the optimal risky portfolio in the Treynor-Black model, macroeconomic forecasts are used
for the _________ and composite forecasts are used for the __________. 
 

A.  passive index portfolio; active portfolio

B.  active portfolio, passive index portfolio
C.  expected return; standard deviation
D.  expected return ; beta coefficient
E.  alpha coefficient; beta coefficient

The two factors combine to determine the optimal risky portfolio.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 
42. The beta of an active portfolio is 1.45. The standard deviation of the returns on the market index is 22%.
The nonsystematic variance of the active portfolio is 3%. The standard deviation of the returns on the
active portfolio is 
 

A.  36.30%.
B.  5.84%.
C.  19.60%.
D.  24.17%.
E.  26.0%.

s = [(1.45)2(0.22)2 + 0.03]1/2 = [0.13176]1/2 = 36.3%.

 
AACSB: Analytic
Blooms: Apply
Difficulty: Challenge
Topic: Active Management
 

27-34
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McGraw-Hill Education.
43. Consider the Treynor-Black model. The alpha of an active portfolio is 1%. The expected return on the
market index is 11%. The variance of return on the market portfolio is 6%. The nonsystematic variance
of the active portfolio is 2%. The risk-free rate of return is 4%. The beta of the active portfolio is 1.1.
The optimal proportion to invest in the active portfolio is 
 

A.  45%.
B.  25%.
C.  50%.
D.  100%.

wO = [1%/2%]/[(11% - 4%)/6%] = .4286, or 42.86%; w* = .4286/[1 + (1 - 1.1).4286] = 0.4478.

 
AACSB: Analytic
Blooms: Apply
Difficulty: Challenge
Topic: Active Management
 
44. Consider the Treynor-Black model. The alpha of an active portfolio is 3%. The expected return on the
market index is 10%. The variance of the return on the market portfolio is 4%. The nonsystematic
variance of the active portfolio is 2%. The risk-free rate of return is 3%. The beta of the active portfolio
is 1.15. The optimal proportion to invest in the active portfolio is 
 

A.  48.7%.
B.  98.4%.
C.  51.3%.
D.  100.0%.

wO = [3%/2%]/[(10% - 3%)/4%] = 0.857; w* = 0.857/[1 + (1 - 1.15)0.857] = .984, or 98.4%.

 
AACSB: Analytic
Blooms: Apply
Difficulty: Challenge
Topic: Active Management
 

27-35
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McGraw-Hill Education.
45. Consider the Treynor-Black model. The alpha of an active portfolio is 2%. The expected return on the
market index is 12%. The variance of the return on the market portfolio is 4%. The nonsystematic
variance of the active portfolio is 2%. The risk-free rate of return is 3%. The beta of the active portfolio
is 1.15. The optimal proportion to invest in the active portfolio is 
 

A.  48.7%.
B.  98.3%.
C.  47.6%.
D.  100.0%.

wO = [2%/2%]/[(12% - 3%)/4%] = 0.444; w* = 0.444/[1 + (1 - 1.15) 0.444] = .476, or 47.6%.

 
AACSB: Analytic
Blooms: Apply
Difficulty: Challenge
Topic: Active Management
 
46. Perfect timing ability is equivalent to having __________ on the market portfolio. 
 

A.  a call option

B.  a futures contract
C.  a put option
D.  a commodities contract

Perfect foresight is equivalent to holding a call option on the equity portfolio.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Basic
Topic: Active Management
 

27-36
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McGraw-Hill Education.
47. Kane, Marcus, and Trippi (1999) show that the annualized fee that investors should be willing to pay for
active management, over and above the fee charged by a passive index fund, depends on

I) the investor's coefficient of risk aversion.

II) the value of at-the-money call option on the market portfolio.
III) the value of out-of-the-money call option on the market portfolio.
IV) the precision of the security analyst.
V) the distribution of the squared information ratio of in the universe of securities. 
 

A.  I, II, and IV

B.  I, III, and V
C.  II, IV, and V
D.  I, IV, and V
E.  II, III, and V

Kane, Marcus, and Trippi (1999) show that the annualized fee that investors should be willing to pay for
active management, over and above the fee charged by a passive index fund, depends on the investor's
coefficient of risk aversion, the precision of the security analyst, and the distribution of the squared
information ratio of in the universe of securities.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 

27-37
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McGraw-Hill Education.
48. Kane, Marcus, and Trippi (1999) show that the annualized fee that investors should be willing to pay for
active management, over and above the fee charged by a passive index fund, does not depend on

I) the investor's coefficient of risk aversion.

II) the value of at-the-money call option on the market portfolio.
III) the value of out-of-the-money call option on the market portfolio.
IV) the precision of the security analyst.
V) the distribution of the squared information ratio of in the universe of securities. 
 

A.  I, II, and IV

B.  II, III, and V
C.  II and III
D.  I, IV, and V
E.  II, IV, and V

Kane, Marcus, and Trippi (1999) show that the annualized fee that investors should be willing to pay for
active management, over and above the fee charged by a passive index fund, depends on the investor's
coefficient of risk aversion, the precision of the security analyst, and the distribution of the squared
information ratio of in the universe of securities.

 
AACSB: Analytic
Blooms: Remember
Difficulty: Intermediate
Topic: Active Management
 
 

Short Answer Questions

 

49. Discuss the Treynor-Black model. 

 

The Treynor-Black estimates the alpha, beta, and residual risk of securities under consideration for a
portfolio. The model uses these estimates to determine the optimal weights of each of these securities in
the portfolio. These composite estimates for the active portfolio and the macroeconomic forecasts for
the passive index portfolio are used to determine the optimal risky portfolio, which will be a
combination of the passive and active portfolios.

Feedback: The purpose of this question is to ascertain if the student understands the basic concepts
behind this model, which allows the portfolio manager to utilize both active and passive components of
portfolio building to obtain an optimal portfolio.

 
AACSB: Reflective Thinking

27-38
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 Blooms: Understand
Difficulty: Intermediate
Topic: Active Management
 
50. You have a record of an analyst's past forecasts of alpha. Describe how you would use this information
within the context of the Treynor-Black model to determine the forecasting ability of the analyst. 
 

You can use the index model and valid estimates of beta, you can estimate the ex-post alphas from the
average realized return and the return on the market index. The equation is

   

Then you would estimate a regression of the forecasted alphas on the realized alphas as in the equation

 The coefficients a0 and a1 reflect the bias in the forecasts. If there is no bias a0 =
0 and a1 = 1. The forecast errors are uncorrelated with the true alpha, so the variance of the forecast is

To measure the value of the forecast, you would use the squared correlation coefficient between the

forecasts and the realizations. This can also be determined by the formula    If the
analyst has perfect forecasting ability the correlation coefficient will be 1. If the analyst has no ability
then the correlation coefficient will be 0. For values in between 0 and 1 you can adjust the forecasts by
multiplying by the correlation.

Feedback: The value of active management depends on the analyst's ability to forecast accurately. The
best way to exploit analysts' forecasts is with the Treynor-Black model.

 
AACSB: Reflective Thinking
Blooms: Understand
Difficulty: Challenge
Topic: Active Management
 

27-39
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