1. CHAPTER 27 Investments The Theory of Active Portfolio Management Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Cover image

2. 27- 2 Cover image Overview  Treynor-Black model –Optimization using analysts’ forecasts of superior performance –Adjusting model for tracking error –Adjusting model for analyst forecast error  Black-Litterman model

3. 27- 3 Cover image Table 27.1 Construction and Properties of the Optimal Risky Portfolio (properties 1-5)

4. 27- 4 Cover image Table 27.1 Construction and Properties of the Optimal Risky Portfolio (properties 6-11)

5. 27- 5 Cover image Table 27.2 Stock Prices and Analysts’ Target Prices for June 1, 2006

6. 27- 6 Cover image Figure 27.1 Rates of Return on the S&P 500 (GSPC) and the Six Stocks, June 2005 – May 2006

7. 27- 7 Cover image Table 27.3 The Optimal Risky Portfolio with the Analysts’ New Forecasts

8. 27- 8 Cover image Table 27.4 The Optimal Risk Portfolio with Constraint on the Active Portfolio (WA < 1)

9. 27- 9 Cover image Figure 27.2 Reduced Efficiency when Benchmark Is Lowered

10. 27- 10 Cover image Table 27.5 The Optimal Risky Portfolio with the Analysts’ New Forecasts (benchmark risk constrained to 3.85%)

11. 27- 11 Cover image Figure 27.3 Histogram of the Alpha Forecast

12. 27- 12 Cover image Figure 27.4 Organizational Chart for Portfolio Management

13. 27- 13 Cover image Steps in the Black-Litterman Model  Step 1: Estimate the covariance matrix from historical data  Step 2: Determine a baseline forecast  Step 3: Integrating the manager’s private views  Step 4: Developing revised (posterior) expectations  Step 5: Apply portfolio optimization

14. 27- 14 Cover image Figure 27.5 Sensitivity of Black Litterman Portfolio Performance to Confidence Level (view is correct)

15. 27- 15 Cover image Figure 27.6 Sensitivity of Black Litterman Portfolio Performance to Confidence Level (view is false)

16. 27- 16 Cover image Table 27.6 M-Square for the Portfolio, Actual Forecasts

17. 27- 17 Cover image Table 27.7 M-Square for the Simulated Portfolios

18. 27- 18 Cover image Concluding Remarks on the Theory of Active Investments  The gap between theory and practice has been narrowing in recent years  The CFA is expanding knowledge base in the industry  Specific lack of application of the Treynor-Black model may be related to lack of application of adjusting for analysts’ errors