Treynor On Institutional Investing E-Book

Jack L. Treynor

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 953

Veröffentlichungsjahr: 2011

Beschreibung

Praise for TREYNOR ON INSTITUTIONAL INVESTING "Jack Treynor has a mind of his own. I mean that as the highest compliment. Jack Treynor sees what no one else sees, thinks what no one else thinks, explains what no one else explains. You will learn more in fifteen minutes with Jack Treynor than in a full hour with most pundits. You will work hard but you will see things, think things, and understand things as never before. This book is a most valuable treasure, gleaming with Jack Treynor's brilliance." -Peter L. Bernstein, author, Capital Ideas Evolving "Vintage Treynor. This is a must-own reference for anyone involved in institutional asset management. It assembles - in one place - many of the important insights of one of the most provocative and creative players in the finance world over the past half-century." -Robert D. Arnott, Chairman, Research Affiliates, and Former Editor, Financial Analysts Journal "As a practicing investment manager, Treynor always preferred brilliance to soundness. Identifying the flaws in conventional thinking, he shows both the theorist and the practitioner where to invest time in their search for excess return." -Perry Mehrling, Professor of Economics, Barnard College, Columbia University, author, Fischer Black and the Revolutionary Idea of Finance "Jack Treynor's new book brings together a lifetime of exploring the important questions surrounding the sophisticated investor's task. Readers of Treynor on Institutional Investing will be richly rewarded by the insights the author has developed about both the practical and the conceptual keys to successful investing." -Samuel L. Hayes, III, Jacob Schiff Professor of Investment Banking Emeritus, Harvard Business School

Leseprobe

Contents

Foreword

Preface

Acknowledgments

Introduction

Part One: Risk

Chapter 1: Using Portfolio Composition to Estimate Risk

Chapter 2: Business versus Statistical Price Risk

Chapter 3: Specific Risk

Chapter 4: On the Quality of Municipal Bonds

How Cities Compete

The Value of a City

Implications for Bond Quality

Appendix 4.1

Chapter 5: Time Diversification

A Parable

The Buy-and-Hold Investor

Time Diversification

Risk and Reward

Terminal Dollars

Constant Dollar Risk

Inflation

An Approximation

The Role of Beta

Accuracy of The Approximation

Rebalancing

The Evidence

Implementing The Approximation Portfolio

Should Risk Decline with Age?

Part Two: CAPM

Chapter 6: Toward a Theory of Market Value of Risky Assets

Chapter 7: Portfolio Theory Is Inconsistent with the Efficient Market Hypothesis

Chapter 8: In Defense of the CAPM

Part Three: Performance Measurement

Chapter 9: The Coming Revolution

Chapter 10: How to Rate Management of Investment Funds

Analyzing Risk

The Characteristic Line

Performance Measure

Rating Management

Conclusion

Appendix 10.1

Chapter 11: Can Mutual Funds Outguess the Market?

Debated Responsibilities

Analytical Approach

Chapter 12: The Future of Performance Measurement

Part Four: Economics

Chapter 13: Unemployment and Inflation

Inflation and Stock Prices

Chapter 14: What Professor Galbraith Neglected to Tell His Television Audience

I

II

III

Chapter 15: The Financial Objective in the Widely Held Corporation

Management Ends

Management Means

Financial Power

Stocks, Not Flows

Share Value Maximization is Management’s Objective

Chapter 16: The Real Cost of Inflation

Chapter 17: The Fiscal Burden

The Fiscal Burden

Implications for Investment

The Burden Ratio

Interest Rates

Conclusion

Appendix 17.1

Consolidated Financial Statements

Chapter 18: A Modest Proposal

The Calculation: Maximizing Labor’s After-Tax Wage

Chapter 19: A More Modest Proposal

The Proof

The Quadrennial Market Cycle

Chapter 20: Real Growth, Government Spending, and Private Investment

Isn’t It Time to Get the Country Moving Again?

What does Government Spending Have to do with Private Investment?

Does Government Spending Create Jobs?

Government Spending versus Private Investment

What about Economic Instability?

Isn’t the Alternative Ineffectual?

Appendix 20.1

Chapter 21: Securities Law and Public Policy

Chapter 22: Shirtsleeves to Shirtsleeves in Three Generations

Wealth Distribution

Changes in Wealth

Appendix 22.1

Rate of Wealth Changes

Chapter 23: Is Training a Good Investment?

The Unskilled Wage

The Plant-Labor Balance

The Consequences of Training

Capacity Additions and Training

Summary

Chapter 24: The Fifth Horseman

Chapter 25: A Theory of Inflation

Introduction

Section 1: Inflation Surprise in the Closed Economy

Section 2: Inflation Trends in The Open Economy

Section 3: Open Economies in A Closed World

How Inflation Rates Change

Testing the Model

Conclusions

Appendix 25.1 Devising Meaningful Tests

Appendix 25.2 The Phillips Curves

Appendix 25.3

Appendix 25.4 Estimating Openness

Chapter 26: How to Regulate a Monopoly

The Regulation Problem

A New Approach

Chapter 27: Man’s Most Important Invention

Chapter 28: Will the Phillips Curve Cause World War III?

Cause of Inflation

U.S. Experience in the 1930s

Japan’s Problem

Japan’s Experience in the 1990s

Shrinking Work Forces in Europe

Escaping from a Liquidity Trap

Conclusion

Part Five: Trading

Chapter 29: What Kind of Security Analysis Contributes to Performance?

Chapter 30: The Only Game in Town

The Market Maker: Key to the Stock Market Game

The Market Consensus

Coppering the Public

Chapter 31: What the Courts Ought to Know about Prudence

Chapter 32: De Facto Market Makers

Chapter 33: The Power of a Few Knowledgeable Investors

Chapter 34: Four Rules for Successful Trading

Chapter 35: Index Funds and Active Portfolio Management

Chapter 36: Opportunities and Hazards in Investigative Research

Chapter 37: What Does It Take to Win the Trading Game?

A Third View

Why Profit Opportunities Exist

The Price of Executing

The Cost of Trading

Success in Trading

Implications for Research

Implications for Portfolio Managers

Conclusion

Appendix 37.1: The Cost of Trading

Chapter 38: In Defense of Technical Analysis

The Probability Distribution of The Market Date

Conclusions

Chapter 39: The Economics of the Dealer Function

Determining the Dealer’s Spread

Determining the Dealer’s Mean Price

Valuation Errors in VBTs’ Estimates

The Economics of Investing

Appendix 39.1

Chapter 40: Market Manipulation

Chapter 41: Types and Motivations of Market Participants

Key Elements in Investment Performance

Trading, as well as Holding, Risks

Invisible Trading Costs Defined

Exchanging Price for Time

Active Investing is a Game of Odds

How We Think About the Nature of the Game

Conclusion

Question and Answer Session

Chapter 42: The Invisible Costs of Trading

Key Elements in Investment Performance

Active Investing Incurs Trading, as well as Holding, Risks

Invisible Trading Costs Defined

Exchanging Price for Time

Active Investing is a Game of Odds

How We Think About the Nature of the Game Affects Our Performance

Conclusions

Chapter 43: Zero Sum

What is the Active Management Game?

How We Win and Lose

Conclusion

Chapter 44: Insider Trading

Jack L. Treynor

Dean Lebaron

Part Six: Accounting

Chapter 45: Financial Reporting—for Whom?

Chapter 46: The Revenue-Expense View of Accrual Accounting

Chapter 47: The Trouble with Earnings

The Price of Relevance

In Conclusion

Chapter 48: The Trueblood Report

Chapter 49: A Hard Look at Traditional Disclosure

Chapter 50: The Trouble with Corporate Disclosure

Part Seven: Investment Value

Chapter 51: Top-Down Economic Forecasts and Securities Selection

Chapter 52: The Value of Control

What Berle and Means Foresaw

The Takeover Premium

The Arithmetic of Leveraged Buyouts

Conclusion

Chapter 53: Economic Life versus Physical Life

Chapter 54: The Investment Value of Plant

A New Tractor

The High-Cost Producer

How Plant Additions Affect the Supply Curve

Economic Life of Plant

The Value of Future Economic Rents

Physical Versus Economic Life

Marginal Cost Decays with Time

Technology and the Supply Curve

Chapter 55: Growth Companies

The Concept of Brand Franchise

Competitors and Producers

Marketing Peace versus Marketing War

Economic Goodwill and Growth

Payback in Marketing

Conclusion

Chapter 56: Bulls, Bears, and Market Bubbles

Are Bubbles Accidental?

Are Bubbles Irrational?

Appendix 56.1

Chapter 57: The Canonical Market Bubble

The Size of Wealth Changes

The Precondition for Market Bubbles

Passive Investors

In a Bubble, Who Buys? Who Sells?

Appendix 57.1

Chapter 58: The Investment Value of Brand Franchise

Branch Franchise Power

Marketing and the Brand Franchise

The Two Meanings of “Competition”

Implications for Antitrust

Appendix 58.1

Chapter 59: The Investment Value of an Idea

Why Ideas are Risky

When will the New Replace the Old?

Growth Companies

Systematic Risk

Wealth Borrowers and Wealth Lenders

Entrepreneurial Risk

Part Eight: Active Management

Chapter 60: How to Use Security Analysis to Improve Portfolio Selection

Definitions

The Sharpe and Appraisal Ratios

Deriving Forecasts of Independent Returns From Security Analysis

Summary

Appendix 60.1

Chapter 61: Why Clients Fail

Chapter 62: Long-Term Investing

The Returns to Long-Term Investing

Appendix 62.1

Chapter 63: The Institutional Shortfall

Chapter 64: Persuasion and Long-Term Investing

Chapter 65: Is “Reasonable Knowledge” Enough?

Chapter 66: How Technical Should Investment Management Be?

Chapter 67: If You Can Forecast the Market, You Don’t Need Anything Else

Chapter 68: Market Efficiency and the Bean Jar Experiment

The Bean Jar

Published Research and Market Prices

Trading on Information

Conclusion

Appendix 68.1

Chapter 69: Information-Based Investing

Conclusion

Chapter 70: The 10 Most Important Questions to Ask in Selecting a Money Manager

Part Nine: Pensions

Chapter 71: Risk and Reward in Corporate Pension Funds

Chapter 72: An Investor’s Guide to the Index Fund Controversy

Our Approach

Index Fund Concept

Practical Versions of Index Funds

Managed Portfolios

Conclusion

Appendix 72.1

I

II

Chapter 73: The Principles of Corporate Pension Finance

Implications for Pension Claims

The Pension Actuary’s Approach

Enter Erisa

Are Private Creditors Worse off Under Erisa?

Liability Insurance

Summary

Chapter 74: Pension Claims and Corporate Assets

The Pension Burden Prior to Erisa

A Practical Example

Part Ten: Cases

Chapter 75: Feathered Feast

Feathered Feast, Inc.

Questions

Chapter 76: An Extraordinarily Cheap Trade

Questions

Chapter 77: The Gauntlet

Questions

Discussion

Chapter 78: A Prudent Man

Chapter 79: Default—Shawnee Manufacturing

Questions

Default Discussion

Chapter 80: Public Voting

Questions

Public Voting—Discussion

Chapter 81: Fiduciary Funds

Discussion

Chapter 82: Poosha-Carta Food Stores

Discussion

Chapter 83: The Fed Watchers

Discussion

Chapter 84: Betting on Management

Discussion

Chapter 85: Financial Literacy

Discussion

Chapter 86: Cereal Mergers

Questions

Chapter 87: Quiz for Fed Candidates

Chapter 88: When Plant Wears Out

Discussion

Chapter 89: Answers to Quiz for Fed Candidates

Chapter 90: Gas Caps and the Sherman Act

Discussion

Chapter 91: The Worldwide Financier

Questions

Chapter 92: Reifen AG

Questions for Discussion

Part Eleven: Miscellaneous

Chapter 93: Wha’ Hoppen’?

Chapter 94: Portfolio Insurance and Market Volatility

Calculating the Impact

Chapter 95: Betting on Good Management

Chapter 96: Remembering Fischer Black

Chapter 97: Why Market-Valuation-Indifferent Indexing Works

The Basic Equation

Implications for MVI Indexing

Eliminating Small-Cap BIAS

The Source of MVI’s Advantage

Trading Costs

Conclusion

Appendix 97.1: Reversion to True Value

Index

ADDITIONAL PRAISE FOR TREYNOR ON INSTITUTIONAL INVESTING

“Along with Fischer Black, Jack has one of the most creative minds ever to think about financial economics. He has ideas, and more ideas, and like Fischer he swings at losers, but once in a while he really cracks one out of the park. Sometimes Jack is so far ahead of the umpire of the day that what first looks like a foul ball turns into an in-the-park homer, after one takes the time to inspect the replay more carefully. So step up to the plate with Jack, and take a swing.”

—Mark Rubinstein, Professor of Finance, University of California at Berkeley, and author, A History of the Theory of Investments: My Annotated Bibliography

“Simply put, Jack Treynor is one of the giants in modern financial theory, having generated a virtually continuous flow of deep insights that have advanced our understanding of how investors behave and how markets evolve. However, because he was so often well ahead of his time, his work and its influence on the field has not been as broadly recognized as it should be. This treasure trove of Treynor’s writings will help rectify that situation. By diving into any one of his papers, the reader will emerge with a new slant on the topic, and be so much the wiser.”

—Martin L. Leibowitz, Managing Director, Morgan Stanley and Former CIO of TIAA-CREF

“This long overdue volume tracing the development of capital market theory and practice is a fascinating and insightful read covering over 40 years of Jack Treynor’s published work. Unbelievable in scope and breadth for a single author, Treynor has pioneered thinking in nine major capital market topics. The reader will also be challenged by 18 short case studies.”

—Donald L. Tuttle, PhD, CFA, Vice President (retired), CFA Institute, Charlottesville, VA

“Jack Treynor is one of the most respected contributors to the revolution in financial markets theory in the last half of the 20th century. The investment profession will be forever grateful to Jack for his intellect and insights and his relentless pursuit of discoveries that provide an advantage to the prepared and patient investor. Through his marvelous compilation of his articles and essays, the CFA Institute has recognized Jack’s contributions and shared his legacy with current and future generations.”

—John L. Maginn, CFA, Retired CIO Mutual of Omaha, President, Maginn Associates, Inc.

“Treynor on Institutional Investing is matchless. Jack Treynor, enigmatic market observer and participant, collects most of his investment wisdom—developed over a lifetime—in this phenomenal volume. Mr. Treynor is the missing link in financial economics; one whom many had overlooked and yet who, as the protege of Franco Modigliani and as the mentor of Fischer Black, first invented the Capital Asset Pricing Model. The insights in this amazing volume range far beyond asset pricing, covering risk, performance evaluation, micro- and macroeconomics, trading, accounting, valuation, active management, pension finance, and a host of case studies. If you only ever purchase one book on investing, Treynor on Institutional Investing is the bible!”

—Craig W. French, Partner, Director of Risk & Quantitative Research, Corbin Capital Partners, L.P.

“Jack Treynor is the quintessential giant upon whose shoulders we have stood to peer further into the mysterious and complex world of modern finance. Always ahead of his time, Jack challenges us to question conventional wisdom, and with the benefit of hindsight, our appreciation for Jack’s wisdom has grown deeper. This marvelous collection of Jack’s papers serves as testimony to his unique originality and prodigious intellect.”

—Mark Kritzman, President and CEO, Windham Capital Management, LLC

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Copyright © 2008 by Jack L. Treynor. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada

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Library of Congress Cataloging-in-Publication Data:

Treynor, Jack L.

Treynor on institutional investing / Jack L. Treynor.

p. cm.—(Wiley finance series)

Includes index.

ISBN 978-0-470-11875-7 (cloth)

ISBN-13 978-0-470-11875-7

1. Institutional investments. 2. Portfolio management. I. Title.

HG4521.T685 2007

332.67'253—dc22

2007026266

To Betsy Glassmeyer Treynor, who changed my life from black and white to Technicolor.

Foreword

Jack L. Treynor: An Independent Mind

This book, a collection of the writings of one of the most independent minds to tackle the financial market landscape, captures a number of ways in which the ever-provocative Jack Treynor influenced and touched the professional investment community over a period of decades. He reached many of us in two ways: (1) through published pieces of foresight and analysis that are now well recognized, and (2) through the individual guidance and advice that he has given to many of us. The book is part of a growing trend to recognize the many, and important, accomplishments of this esteemed practitioner.

If there is one way to sum up the contributions made by Treynor (and Walter Bagehot, his pseudonym for articles in CFA Institute’s Financial Analysts Journal [FAJ]), it was captured in Perry Mehrling’s book on the late Fischer Black.1 Treynor is credited by many scholars with drawing Black into the world of finance, and the two collaborated and counterpointed for years. Speaking in 1997 at a meeting of the International Association of Financial Engineers, Nobel Laureate Paul Samuelson suggested that a “Hall of Fame of Theoretical Finance” list should include Myron Scholes, Robert Merton (who would go on to be awarded Nobel Prizes), and Fischer Black (who died before he could receive a Nobel). In the middle of his speech, after mentioning the innovation of the capital asset pricing model (CAPM) for which William Sharpe had won the Nobel Prize in 1990, another Nobel Prize winner, Franco Modigliani, rose and said, “What about Treynor? You forgot Treynor!”

He knew Treynor had developed a CAPM in 1962, because Treynor had shown the model to him, and Modigliani regretted that he had not seen its potential and encouraged Treynor to pursue it. “I made a mistake with Treynor,” he has noted. Treynor discovered the CAPM as a part of a journey to find better answers to the question of what was the appropriate discount rate to be used in capital-budgeting projects.

Ultimately, Black would write a letter of appreciation to Treynor as he was stepping down as editor of the FAJ, which read:

Your own research has been very important. You developed the capital asset pricing model before anyone else. But perhaps your greatest contribution has been through the work of others as Editor of the Financial Analysts Journal. Balancing academic interest, readability, and practical interest in a unique way, you guided issue after brilliant issue toward publication. I hope the profession will be able to repay you in some way.2

CFA Institute, representing the investment profession, broadly, owes a huge debt to Jack Treynor. In 1981 as Treynor’s term with the FAJ was coming to a close, Charley Ellis, CFA wrote:

Financial analysts have been striving for many years to develop a strong profession. A profession depends explicitly upon a comprehensive body of knowledge. Great progress in developing our professional knowledge has been made, but not without the stress of working it out piece by piece and stage by stage. Jack has been a leader in the process of developing our knowledge and our understanding, and he has taken us with him.3

It is long past time for his writings to be gathered into a book that should grace the shelf of every investment professional.

Since the mid-1980s, Treynor has been president of Treynor Capital Management in Palos Verdes Estates, California. Following a major in mathematics from Haverford College, a stint with the U.S. Army, and an MBA with Distinction from the Harvard Business School (after which he stayed on at H.B.S. as a case writer for Bob Anthony in accounting), he was hired by the Operations Research Department at Arthur D. Little in 1956. Subsequently, he was hired by Donald Regan (the same Regan who later became U.S. Treasury Secretary) at Merrill Lynch to provide quantitative investment services to institutions. From 1969 to mid-1981, he presided as editor of the FAJ of what is now CFA Institute. After he left the FAJ, from 1981 to 1985, he was general partner and chief investment officer at the investment management firm of Treynor-Arbit Associates.

In 1985, Treynor earned from CFA Institute the prestigious Nicholas Molodovsky Award, which is presented periodically to individuals who have made outstanding contributions to change the direction of the investment profession. In 2007, he received from CFA Institute our highest commendation—the Professional Excellence Award for exemplary achievement, excellence of practice, and true leadership that have reflected honor upon the investment profession to the highest degree. He is a Distinguished Fellow of the Institute for Quantitative Research in Finance and has received the Employee Benefit Research Institute’s Lillywhite Award.

Treynor is the coauthor of two books and more than 90 papers published in, among others, the Harvard Business Review, Journal of Business, Journal of Finance, Journal of Investment Management, Journal of Portfolio Management, and FAJ. He has taught investment courses at Columbia University and the University of Southern California and has served as director for several investment companies.

This book is more than a valuable collection of some of the leading-edge thoughts of the day by a gifted individual. It is a celebration of a practitioner who, arguably, had more influence over the profession than any other. It celebrates a person whose prime characteristic is an independence of views. In Treynor’s own words, his true interest always “was the analytical problem behind investment decisions.”4 Or as Black wrote, “You started me out in finance and showed me the beauty of the way markets balance bulls and bears, speculators and investors. You taught me to look for buried treasure rather than surface nuggets in the unexplored wilds of research.”5

In fact, Treynor was capable of connecting dots from far enough afield to the seeming point of eccentricity. How else to characterize someone who would bring a jar of red beans into his classroom at the University of Southern California to make a point? He would ask the students to guess how many beans were in the jar. Although the guesses ranged widely, Treynor was able to show that the average guess was close to perfect.

Surface nuggets are illusory. As a result, Jack would test an investment idea by telling others about it. If they easily understood the idea and agreed with the implied conclusion, he would presume the idea was already reflected in the security’s price and move on. If they didn’t see the point, he would conclude that the view was not impounded in the security’s price and would pursue the idea further. I must admit I used the same tactic—usually on relatively sophisticated but unsuspecting investors—when I was in active management. So, of course, you can imagine my delight and disappointment when my old U.S. Equity team admitted that they were using me in the same manner after I was promoted to chief investment officer. When I was that one step farther away from the action, I no longer had the “edge.” Let that be a warning.

Much of Treynor’s work was being done at a time when academia was generally focused on a theory of market efficiency. On that subject, Treynor’s statement is what sustains many an applied manager today:

[A]lthough the market is highly competitive, market efficiency as such should not prevent active investors from outperforming the market, by capitalizing on either inefficiencies in the propagation of information or inefficiencies in valuation.6

Treynor’s broad contribution can be seen in the way the material of this book is organized. Many know that his work goes well beyond capital asset pricing and the performance measurement extension. The headings of this book give evidence to this breadth:

Risk

CAPM

Performance Measurement

Economics

Trading

Accounting

Investment Value

Active Management

Pensions

Cases

Miscellaneous

Treynor makes important contributions in a number of areas that are fundamental to the investment management profession as a whole and CFA Institute in particular. His work addresses most of the ten topic areas that are the foundation for the CFA Program’s examinations. Articles addressing the need to measure risk, valuation, capital asset pricing, capital budgeting, bond quality, active versus passive management, earnings quality, and options theory are but a few covered by this prolific writer. But his work extends beyond core topics and speaks to the whole of the investment business. For example, the CFA Institute Centre for financial Market Integrity is organized into four areas: standards of practice, capital markets policy, investment performance standards, and corporate disclosure. Treynor has made analytical contributions to each of these areas, which are traditionally thought of as advocacy.

In his early editorials and articles in the FAJ on stewardship, Treynor argued that investment practitioners, to be worthy of being called professionals, needed to move away from a focus on the securities industry toward a focus on the ultimate customer. He was critical of the emphasis on persuasion rather than performance. The principle, he believed, should not be what could be sold in the market for the benefit of Wall Street but the intrinsic value of the investment to the end user—whether beneficiary of a pension plan or mutual fund investor. We at CFA Institute also believe that the ultimate owner should be the prime beneficiary of the work we do.

With William Priest and Patrick Regan, Treynor correctly predicted the difficulties our pension system would face under ERISA and the Pension Benefit Guaranty Corporation, both created in 1974.7 His early work on performance estimation was geared toward giving clients some rational means by which to look through the clutter of all the numbers to make inferences of skill on the part of investment managers, which is a foundation of the CFA Institute’s work with Global Investment Performance Standards (GIPS). And his early papers on the accounting-driven nature of earnings statements, versus the investor need for statements that showed the economic rent firms were capturing, were a bulwark on which our voice for the financial statement user could be based. Moreover, he has written on securities law and regulation.

Equally important to Treynor’s public contributions, but impossible to quantify, is the individual guidance and advice that he gave to individuals. Many of us can share stories of how Jack Treynor helped and influenced us on a personal scale, even though most of us doubt that he would even remember us. Allow me to share a couple of my own stories.

As the new volunteer head of the Candidate Curriculum Committee for economics at CFA Institute in the mid-1980s, I was struggling to find relevant material of an economic nature for the company research element of our examinations. From an economist’s viewpoint, security analysis seemed to sit in a bit of a wasteland between economic theories of supply and demand and accounting approaches to financial statement analysis. Where were the economically principled articles to help a security analyst actually estimate cash flows? I called around and, of course, was directed to Jack Treynor. His first thought was to look at the appendix of John Burr Williams’s 1938 gospel on valuation, in which the competitive position and evolution of the General Motors Company were described.8 From that book, our discussion led to Michael Porter, Mike Spence, and Barry Nalebuff.9 We accurately concluded there was, seemingly, a lack of supply–demand analysis in the practitioner world. We had great theory, but Jack also provided the applications.

The firm Treynor-Arbit evolved in 1985 out of American National Bank, a midsized gem in Chicago (American National was a pioneer in index fund investing with Rex Sinquefield). I was working down the street at First Chicago. When I took over the investment management function of domestic equities, two external firms had a large impact on what I subsequently attempted to do. One was Treynor-Arbit, with its extremely rigorous and nearly academic (by practitioner standards) approach to uncovering and documenting errors the market was making in understanding and pricing of industries and groups of securities. Here was a model of research, in my mind, that I could borrow from. And I did. It helped that I knew a few of Treynor and Hal Arbit’s analysts.

Finally, in 1988, while I was working on a chapter on capital markets for Maginn and Tuttle’s textbook, I needed to think particularly carefully, for various reasons, about the relevance of technical analysis.10 No disrespect intended, but most books and articles on technical analysis at the time lacked rigor and care—despite the fact that much quantitative management is, essentially, sophisticated technical analysis. Treynor’s presentation and writings on technical analysis provided a thoughtful way to get one’s arms around this oft-used paradigm. This instance provides a valuable lesson: If you really understand deeply the nature of research and markets, you can understand how even easily dismissed theories have elements of value.

This book contains many wonderful articles. You could not do better than to sit down and enjoy them today, years after they were written, both for the perspective they provide and the timeless nature of some of them. I’m sure you’ll see as you work through this volume the great independent mind that is Jack Treynor.

We also and always hope you use this book to continue your commitment to fair and free capital markets built on a foundation of trust and bred from the integrity of market participants and professionals like you.

Jeff Diermeier, CFA

President and chief executive officer

CFA Institute

April 2007

Notes

1. Fischer Black and the Revolutionary Idea of Finance (Hoboken, NJ: John Wiley & Sons, 2005).

2. “An Open Letter to Jack Treynor” (July–August 1981): 14.

3. “Jack Has Never Been Easy” (July–August): 25.

4. “Ideas for the People Who Make Decisions,” FAJ (July–August 2005): 6–8; reprinted in Bold Thinking on Investment Management (Charlottesville, VA: CFA Institute, 2005): 238–240.

5. “An Open Letter to Jack Treynor,” FAJ (July–August 1981):14.

6. “What Does It Take to Win the Trading Game?” FAJ (January–February 1981): 57.

7. See The Financial Reality of Pension Funding under ERISA by Jack L. Treynor, Patrick J. Regan, and William W. Priest, Jr. (Homewood, IL: Irwin, 1976).

8. The Theory of Investment Value (Cambridge, MA: Harvard University Press).

9. Porter’s influential books at that time were Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press, first published in 1980) and Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, first published in 1985). A. Michael Spence won the Nobel Prize in Economics in 2001 for work on the dynamics of information flows and market development. Barry Nalebuff is coauthor with Avinash Dixit of Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life (New York: Norton Paperback, 1993; first published in 1991).

10. The book was Managing Investment Portfolios: A Dynamic Process by John L. Maginn and Donald L. Tuttle; the third edition includes editors Jerald E. Pinto and Dennis W. McLeavey (Charlottesville, VA: CFA Institute, 2007).

Preface

Much of the pressure on investment institutions comes from two facts:

1. Results are made public.

2. For every winner there is a loser. Every investor can benefit from a rising market, but what he gains from trading, his counterparty loses.

Not surprisingly, money managers haven’t been willing to stand pat with comfortable rituals. They want to know what works—and what doesn’t work.

Because most retail investors can’t afford to own enough stocks to be well diversified, they can’t readily measure the market component of their return. So they don’t know whether they are gaining or losing from their trading. Without a meaningful learning experience, retail investors make the same mistakes over and over again.

Since most institutional portfolios—mutual funds, pension funds, endowment funds—hold dozens, if not hundreds of stocks, they are reasonably well diversified, making it easier to distinguish between the two kinds of gains and losses. Perhaps it isn’t entirely accidental that institutional investors have been steadily advancing their understanding of the investment problem. As the gap in understanding relative to retail investors has widened over the last 40 years, institutional investing has exploded into a profession that manages more than $26.5 trillion1 in the United States alone.

Many retail investors with demanding jobs reach a point in their careers where their own investment portfolio has become too important to ignore any longer. They know they are good at making business or professional decisions, but they sense that investment decisions are different. Fortunately, money management isn’t rocket science. Whether they want to make conversations with an advisor more rewarding or prepare themselves for responsibilities on the boards of pension, endowment, or mutual funds, this book can be helpful.

The articles draw on the author’s experience as a management consultant, money manager, and fund director.2 First published in the Harvard Business Review, the Journal of Business, the Journal of Finance, the Journal of Portfolio Management, the Journal of Investment Management, and, of course, the journal the author edited for many years—Financial Analysts Journal, more than 16 of the papers in this book have been included in anthologies of finance and investing.

Jack L. Treynor

Palos Verdes Estates, CA

April 2007

Notes

1. Pazarbasioglu, Ceyla; Mangal, Goswami; Jack, Ree. “The Changing Face of Investors,” Finance and Development, A quarterly magazine of the International Monetary Fund, March 2007.

2. The author’s consulting experience included casework for Philco, United Fruit, Royal Dutch Shell, the Irish Sugar Company, American Brake Shoe, British Aircraft Corporation, Minneapolis Honeywell, and others. He was a money manager for Treynor-Arbit Associates and fund director for over 30 years with Eaton Vance and its predecessor firms.

Acknowledgments

The following is a very incomplete list of people I am indebted to, often learning far more from them than they could possibly learn from me.

Harvard Business School—to Robert N. Anthony who invited me to be a case writer.

Arthur D. Little, Inc.—to Phil Donham and Bruce Henderson, for giving me the opportunity to work on management consulting cases at Arthur D. Little, Inc. and to Bill Ackerman, a consultant to ADL on the United Fruit Case.

Merrill Lynch—to Jim Corbett.

Financial Analysts Journal—to Nick Molodovsky and especially Frank Block, for taking the gamble on me for the Financial Analysts Journal.

Eaton Vance—to Don Dwight, Sam Hayes, and Lynn Stout.

Research Affiliates—to Rob Arnott.

MIT—to Franco Modigliani, for inviting me to come to MIT, choosing my courses, and breaking my paper into two parts—the right part and the wrong part.

The Center for Research in Security Prices (CRSP) at the University of Chicago—to Jim Lorie and CRSP.

Yale—to Howard Phelan and John Ecklund.

London Business School—to Dick Brealey and Steve Schaefer.

Northwestern University—to Robert Korajczyk and Al Rappapport.

The Institute for Quantitative Research in Finance—to Roger Murray, Jim Farrell, Gifford Fong, and Peter Williamson.

CFA Institute—to Don Tuttle and John Maginn.

And to Fischer Black.

J. L. T.

Introduction

How a Profession Preserves Its Vitality

The word “professional” has many meanings. The dictionary definition coming closest to what we mean when we speak of the “professional” security analyst is “engaged in a calling requiring specialized knowledge and often long and intensive academic preparation.” Even this definition seems somehow inadequate. What is it that the security analyst has in common with doctors, lawyers, engineers, and architects? The following characteristics, at least:

1. They draw on a body of formal knowledge to solve practical problems that often require going beyond that knowledge into gray areas where powers of observation, analysis, judgment, and so forth, play an important role.

2. The professional’s client is entitled to expect that the professional would treat him as he would treat himself. In other words, the relationship between client and professional is not an arm’s-length business relationship.

3. All these professionals have in common a sense of mission, a drive for self-improvement that goes beyond merely attempting to enhance their own individual earning power.

The first of these characteristics is perhaps less well known than the others, yet it may be the most important. The responsibility of the true professional does not stop with what is known. The professional who considers that his responsibility stops when he has exhausted the accepted techniques in his field may have a high income, and several academic degrees after his name, but his role in society is indistinguishable from that of a plumber.

On the other hand, it is precisely because the problems he is trying to solve go beyond the capabilities of present knowledge to solve them that he and his fellow professionals are constantly pressing forward in their search for new knowledge.

Nothing is more deadly to the vitality of a professional than defining his activities in terms of a set of comfortable rituals, rather than in terms of the great unsolved problems his clients have hired him to solve (this tendency is, of course, merely a special case of what Professor Ted Levitt in his famous Harvard Business Review article called “Marketing Myopia”).

Because the solutions are never adequate to the practical problems, it is characteristic of a profession that there is a continuing tension between theory and practice. Sometimes this tension becomes so uncomfortable that both theoreticians and practitioners wish they could cease having anything to do with each other. Both theory and practice can survive that kind of schism, but the pale flame of professionalism cannot.

And it is a pale flame. For what distinguishes a profession from other human endeavors is not the average professional, but the exceptional professional. The latter is always far more important to his profession than his small numbers would suggest. What fraction of all doctors are brain surgeons? What fraction of all lawyers argue cases before the Supreme Court? What fraction of all engineers can invent a Wankel engine or a laser? The essence of the professional is the tireless pursuit of an ideal, and that ideal is approached by very few men.

The quintessentially professional activities in any profession tend to be of, by, and for the exceptional man. The average professional supports these activities, not because they have immediate practical value for him, or because they are tailored to his immediate capabilities and needs, but because they strengthen the common bond of professional aspiration that runs from the least of the men in his profession to the greatest.

Security analysis is a very young profession. In any profession so young there is always some danger that the average man in the profession will lose his sense of mission—his willingness to put the client first, his commitment to client welfare that goes beyond mere practice of accepted technique, his determination to advance the state of knowledge. A Greek philosopher would probably say that, among other things, a profession is a state of becoming. The tension between theory and practice is not too high a price to pay to keep the pale flame of professionalism burning.

PART One

Risk

Risk is about events that we can’t foresee. Is there nevertheless some underlying connection between the frequency of past events and the frequency of future events? Between the magnitude of past risks and the magnitude of future risks? Can connections between past and future risks be quantified in some useful way that is not itself risky?

Paradoxically, the risks that are hardest to quantify are the risks of least concern to the institutional investor. The key is the tendency for certain kinds of risks to occur together—i.e., the degree of correlation between the risks. Although uncorrelated risks are the easiest for an institutional investor to diversify, so-called “market” risks, which can’t be diversified away, are the easiest to quantify.

J.L.T.

CHAPTER 1

Using Portfolio Composition to Estimate Riska

In recent years a number of financial scholars have commented on the marked degree of co-movement in the prices of securities. Statistical techniques have been applied to measuring the character and degree of co-movement by Donald Farrar, Hester and Feeney, and Benjamin King. Perhaps the best known model of stock prices that recognizes and incorporates the co-movement phenomenon is that of William Sharpe. In Sharpe’s model fluctuations in the price of a particular common stock have two causes: (1) fluctuations in the general market level and (2) fluctuations unique to the stock in question. More complicated models than Sharpe’s have been proposed and the Sharpe model has occasionally been criticized as being too simple to fit reality (see for example Benjamin King’s discussion1). Nevertheless, its simplicity gives it great appeal.2

We are not the first to apply simple financial models to practical problems involving risk measurement. Marshall Blume tested the applicability of the Sharpe model to the problems of predicting the risk character of simulated rather than actual portfolios. James Fanning, now of Rockefeller Brothers, and Marc Steglitz of Bankers Trust have measured risk in actual common stocks defined in terms of a related, but different, model and applied the results to estimating the risk character of actual portfolios containing these stocks. Although the present paper has benefited substantially from the work of Fanning and Steglitz, in terms of model and approach, we are much closer to Blume than Fanning and Steglitz.