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7 September 2017 Financial Analysts Journal Book Review

Treynor on Institutional Investing (a review)

  1. James Jackson
This book is a compilation of 97 articles, originally published during the past 46 years, on the research approach, methods, and findings of Jack Treynor—a leading researcher and writer and past editor of the FAJ.

Jack Treynor is one of the premier minds in finance and investment management of the last several decades. His career is particularly impressive in that he is not a pure academician but, rather, a practitioner who understands the value of cutting-edge research and the application of ideas and methods that advance his true interest, which is “the analytical problem behind investment decisions.” Treynor on Institutional Investing reflects his pursuit of this interest, and it allows readers a glimpse into the investment world through his eyes as an investment professional.

The book is a compilation of 97 articles on research methods developed by Treynor that were originally published over the past 46 years in leading finance journals, including the Financial Analysts Journal. Treynor’s methods reflect his belief in market efficiency and the free market of ideas. Over the years, he has consistently tested his own ideas both within the academy and in the public sphere; he has argued for or against many of the leading beliefs and practices in contemporary investment management.

In addition to the articles, the 600-page volume includes a foreword by Jeff Diermeier, CFA, president and CEO of CFA Institute. The hefty size might be off-putting to the casual reader or novice investor, but the book is divided into 11 readable parts that range from risk measurement and estimation to active management and trading. The later chapters of the book are a discussion of recent events and current topics in investment management. Topics that readers may find the most informative include the capital asset pricing model (CAPM), the security market line (SML), benchmark performance, systematic risk versus unsystematic risk, the efficient market hypothesis (EMH), and technical analysis.

To explain investor risk aversion, Treynor recounts the development of the CAPM and the SML in a chapter featuring his seminal paper, “Toward a Theory of Market Value of Risky Assets,” originally presented at a Massachusetts Institute of Technology faculty seminar in 1962 (and first published in 1999). Although the mathematical proofs in “Toward a Theory of Market Value of Risky Assets” may seem cumbersome to some readers, the model’s assumptions and the concept of the market risk premium over the risk-free interest rate should be familiar to students of investment management. Treynor’s graph of the efficient set of optimal investment choices showing the ratio of the market risk premium to the standard error will probably remind readers of the SML with the expected (required) return on the y-axis and the standard error on the x-axis. The line originating at the intersection of the x- and y-axes and rising as risk increases away from the zero point graphs the trade-off between risk and return. This graph is the fundamental depiction of the behavior of rational (risk-averse) investors.

“How to Rate Management of Investment Funds” originally appeared as an article in the January–February 1965 issue of the Harvard Business Review. In this article, Treynor developed a model on the basis of the performance of diversified equity funds to address two key problems in measuring investment manager performance. These problems involve the relationship between systematic versus unsystematic risk:

  1. At times, manager performance may be “swamped by fluctuations in the general market.”
  2. “Measures of average return make no allowance for [individual] investors’ aversions to risk.”

The model consists of the difference between the expected return of the equity portfolio and the return of a fixed-income-only portfolio divided by a measure of volatility that estimates the risk of the equity portfolio. So, at the same time that the model accurately measures the manager’s performance relative to a fixed-income return benchmark, it adjusts the excess return for risk related to the equity portfolio volatility. Treynor’s model does not specify beta as the measurement of portfolio risk; however, the expected return of the equity portfolio is estimated using the relationship between the equity portfolio and the market return.

Over time, researchers have documented beta’s limitations as a reliable measure of market risk (see Fama and French 1992). Consistent with these more recent research findings, Treynor’s model continues to be a basic, objective device for measuring relative performance across investment categories. In an era in which quantitative models have perhaps become too complex (see Buttonwood 2007), readers may find it refreshing to return to the basic notion of return relative to risk as a measure of performance.

In the section called “Trading,” Treynor begins by describing two types of market traders and their respective motivations. He calls into question the ability of each kind of trader to achieve excess returns by considering the traders’ counterparties. Treynor observes that value investors believe they are buying undervalued securities while, at the same time, information investors believe they are buying securities about which they possess superior information. Treynor asks, What are the motivations of the counterparty to each trade, and can both parties be correct? This argument concisely summarizes the limitations of the three forms of the EMH and the ability of investment managers to outperform the market.

By incorporating price (value), information, and time in his argument, “In Defense of Technical Analysis” lends credence to technical analysis as a trading decision method. In addition, “Index Funds and Active Portfolio Management” points out the increasing difficulty active fund managers are facing in their attempts to outperform index funds.

Finally, “Remembering Fischer Black” pays homage to the groundbreaking financial economist who would likely have shared the 1997 Nobel Prize for Economic Science for devising, in collaboration with Myron Scholes, the classic option-pricing model. Treynor recalls his research relationship with Black by describing their collaboration on two papers, how the field of finance changed during Black’s professional life, and how Black stood out among a crowd of very talented people as an “accomplished thinker, . . . a mathematically talented physicist, . . . [who] made a career out of analytical precision.” According to Treynor, Black believed that research was part of a one-way journey that “meant abandoning the comfortable . . . in order to grasp the new.”

The chapter on Black, together with the earlier sections of the book, offers readers the opportunity to explore the ideas of two major contributors to finance and economics. Indeed, because Black’s thoughts and beliefs are reflected throughout the book and align with Treynor’s style of research, readers may want to read “Remembering Fischer Black” first to appreciate fully the nature of the like-minded Treynor’s ideas.

For its final chapter alone, Treynor on Institutional Investing should perhaps be considered essential reading for any student, researcher, or practitioner in finance or financial economics. According to Treynor, ideas exist before they “are reduced to symbols—to words or mathematics.” Based on the body of work assembled in this volume, he has proven that point decisively.


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