Active Porfolio

Active Portfolio Management: The Power of the Treynor-Black Model∗

Alex Kane Graduate School of International Relations and Pacific Studies (IR/PS) University of California, San Diego 9500 Gilman Drive, La Jolla, CA 92093-0519 (Phone) 858-534-5969 (Fax) 858-534-3939 akane@.ucsd.edu Tae-Hwan Kim School of Economics, University of Nottingham University Park, Nottingham NG7 2RD, UK (Phone) 44-115-951-5466 (Fax) 44-115-951-4159 Tae-Hwan.Kim@nottingham.ac.uk Halbert White Department of Economics, University of California, San Diego 9500 Gilman Drive, La Jolla, CA 92093-0508 (Phone) 858-534-3502 (Fax) 858-534-7040 hwhite@weber.ucsd.edu December, 2003

Abstract: The performance of active portfolio methods critically depends on the forecasting ability of the security analyst. The Treynor-Black model provides an efficient way of implementing active investment strategy. Despite its potential benefits, the Treynor-Black model appears to have had little impact on the financial community, mainly because it has been believed that the precision threshold of alpha forecasts used as inputs to the model is too high. We seek to lower the threshold of forecast precision needed to beat a passive-portfolio strategy by improving the econometric methods used in constructing portfolios from security analyst forecasts. We apply shrinkage estimation to beta coefficients and to discount functions for forecasts of stock abnormal returns. OLS estimates, Least Absolute Deviations (LAD) estimates and shrinkage LAD estimates are compared by contribution to portfolio performance. Despite correlations between forecasts and realizations of abnormal returns as low as 0.04, the shrinkage LAD methodology yields superior performance in outof-sample experiments. Key Words: Treynor-Black Model, Abnormal Returns, Sharpe Ratio, M2-measure, Least Absolute Deviations Estimator, Shrinkage LAD estimator.

We would like to thank Clive Granger, Patrick Fitzsimmons, James Hamilton, Bruce Lehmann, Robert Trippi...