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Yet another Treynor Black Model question
The question is as follows:
You are using the Treynor-Black Model for security selection. The optimal portfolio consists 40% of actively managed portfolio with an expected return of 10%. The rest is allocated to the indexed portfolio, which has an expected return of 6%. Your client's requirements are for a portfolio that has an expected return of 10%. Which of the following is the ideal way to achieve this?
A Allocate 100% of the client's funds to the active portfolio
B Allocate 100% of client's funds to the indexed portfolio and borrow money to leverage
C Keep the optimal portfolio allocation the same and leverage the optimal portfolio by borrowing.
Based on my understanding, if 40/60 is the optimum portfolio which would only produce an expected return of 7.6%, you have to alter the weightings towards the actively managed portfolio, but the point is if 40/60 is the optimum how would I be able to adjust it?
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From my understanding, that means to invest the funds from shorting the 60% indexed portfolio to the actively managed portfolio?
How would you be able to benefit from diversifying in the indexed portfolio?
Compare a case where an investor borrowed 50% of the money to fund an initial $100 optimal portfolio. And say the optimal portfolio appreciated by 10%.
Unleveraged return = ($110-$100) / $100 x 100 = 10%
Leveraged return = ($110-$100) / $50 x 100= 20%
His leveraged return doubled when he borrowed 50%. Of course the opposite is true if the price fell. Note that this simple example has not adjusted for the cost of borrowing that money, which would slightly reduce the leveraged return %.
I understand the leverage return, but wouldn't that unbalance the optimum portfolio? Since by borrowing more to invest in the actively managed portfolio, you are actually altering the optimum weighting and towards the actively managed.
if investor wants higher return or riskier portfolio, move up the line (towards the right) so you'll get less risk-free portfolio and more riskier portfolio hence higher return.
thanks @sophie
Thanks @Gary, and welcome to the forum! Are you taking Level 1 June then?
Ps Love that Animated Gif i may have to borrow for work