Treynor-Black model: modifying a Treynor-Black model to account for an analyst's forecast error

Modifying a Treynor-Black model to account for a lack of precision in an analyst's forecast is most likely to include:

A. a correction to the analyst's forecast of alphas based on their prior bias.
B. adjusting the Treynor-Black actively managed portfolio weights using the square of the correlation between the analyst's forecast and realized alphas.
C. reducing portfolio weights by the reciprocal of the analyst's average alpha forecast error as a percentage of expected excess returns.


Answer: B

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An analyst's forecasting ability can be judged based on past performance. The Treynor-Black weightings within actively managed portfolios can be adjusted based on an analyst's prior forecasting ability. The process is to:

• Collect the time-series alpha forecasts for the analyst.
• Calculate the correlation between the alpha forecasts and the realized alphas.
• Square the correlation to derive the R².
• Adjust (shrink) a forecast alpha by multiplying it by the analyst's R².