Jack L. Treynor and the Birth of the Quants

Imagine for a moment an investment world without the accomplishments of Jack L. Treynor.

Treynor was a key member of a tiny group of theorists from which the efficient markets hypothesis (EMH), the capital asset pricing model (CAPM), and the random walk hypothesis emerged in the 1960s. In this imaginary Treynor-less world, mass casino psychology and fund manager guru-worship might rule, unchallenged by any metrics other than crude popularity and marketing spend.

In such a mayhem of speculation and false prophets, the words of British economist John Maynard Keynes would no doubt have proven prescient, “Americans are apt to be unduly interested in discovering what the average opinion believes the average opinion to be; and this national weakness finds its nemesis in the stock market.”

Instead of this counterfactual chaos, the field of quantitative investment was born, a feat due in no small part to Treynor’s battle against prejudice and misunderstanding about the use of mathematics in investment.

Towards the Concept of Market Risk and Beta

Treynor’s early theoretical advance was in defining the spread, or risk premium, between anticipated investor returns over the risk free rate and showing how critical that measure was to solve the portfolio formation problem. In Peter L. Bernstein’s telling, “Markowitz, Tobin, Sharpe, and Modigliani and Miller had all recognized that investors will hold risky assets only if they can expect to earn a premium return for doing so, but none of them had come up with any systematic method for predicting what that risk premium would be. Williams and Graham had been equally silent.”

In Treynor’s model, outlined in an unpublished 1961 paper, “Toward a Theory of the Market Value of Risky Assets,” where to the eternal confusion of practitioners, investors had unlimited borrowing and capacity to short, the anticipated excess return over the risk-free rate per share, “is proportional to the covariance of the investment with the total value of all investments in the market.”

Although the term “beta” didn’t arise until later, Treynor had nailed a theory of market value that incorporates risk premiums and helps objectively define and calibrate investment risk. His unpublished 1961 paper circulated among William F. Sharpe and other theorists, yet controversially it was Sharpe, not Treynor, who was awarded the Nobel Prize nearly 30 years later.

“As a practical matter,” said Bernstein, “nobody today considers the estimates derived from the model (the CAPM) as anywhere near the last word in evaluating assets.” Today, not just the market factor, but a zoo of factors exist and quantitative investors track over 400 factors. A diversity of active and passive forms of quantitative investment increasingly dominates the investment scene with Morningstar saying 40% of US mutual funds are now passively managed.

Bringing Objectivity to Performance Measurement

When the financial crisis came along, many found easy scapegoats in the “Chicago School” of EMH theorists and financial models. But although Treynor was also a key theorist responsible for the CAPM, his perspective was always about how quantitative innovation could directly help investment practitioners and corporates. In that endeavor he made as many enemies as friends.

By the mid-1960s Treynor was working at Arthur D. Little, a consulting firm, on a project to determine why the Yale endowment’s managers seemed so unimpressive by the prevailing returns-based yardsticks. In a tale that will be depressingly familiar to many college endowments, alumni were aggressively pushing various fashionable fund managers all claiming stellar performance:

“The pro they had in mind was . . . Jerry Tsai. So they gave me his record, and I applied my method. It turned out he had a beta of two, and they were looking at a period of time when the market had finally decided we weren’t actually going back into the Great Depression after the Second World War. When you allowed for the fact that Jerry had a beta of two, there wasn’t anything left for Jerry’s alpha. That didn’t make me terribly popular.” — Jack L. Treynor

Characteristically, Treynor chose to publish his innovative method in several articles for the Harvard Business Review, a publication widely read by investment practitioners. Generations of CFA Program examination candidates will be familiar with the Treynor ratio that later emerged to objectively measure the performance of funds adjusted for risk, not just returns. It divides excess returns into market beta and so is easily confused with the Sharpe ratio, which uses standard deviation in the denominator. In the same way that the Sharpe ratio measures excess return per unit of total risk, or standard deviation, the Treynor ratio measures excess return per unit of market risk, or undiversifiable risk, and actually works best with a portfolio that is already quite diversified.

A Lifetime of Ideas for Investment Practice

Treynor will forever be associated with the emergence of CAPM and, of course, his famous ratio, but the story doesn’t end there. Between stints at Arthur D. Little and Merrill Lynch working with Donald Regan, later secretary of the Treasury under President Ronald Reagan, further ingenious papers followed. Of particular note was one co-written with Fischer Black that examined how to use security analysis to improve portfolio selection. Treynor’s topics ranged freely from the macroeconomic sphere (growth theory, inflation, money, and trade) and microeconomics (monopoly and competition) to accounting.

Combining the intellectually novel with the practical application of new ideas was a running theme of Treynor’s work. For example, applied research on pension finance and municipal bonds was influenced by the latest options-pricing theory being developed by Fischer Black and Myron Scholes.

A Difficult Birth for Quant

Treynor often talked of “slow ideas” that are of little interest to the average investor. In one Financial Analysts Journal article, “Long-Term Investing,” Treynor wrote, “When one talks about market efficiency, it is important to distinguish between ideas whose implications are obvious and consequently travel quickly and ideas that require reflection, judgment, and special expertise for their evaluation and consequently travel slowly.” This notion seems just as apt for the progress of his own ideas.

In another FAJ piece, “The Only Game in Town,” written under the pseudonym Walter Bagehot, Treynor evaluated the economics of market making, asking, Why do investors persist in trading despite their dismal long-run trading record and why isn’t trading against the public consistently profitable?

Speaking at a CFA Institute conference in Toronto in 1992, Treynor told investors the most meaningful measure of performance for active portfolios is not total return but the increment in return that results from trading. For Treynor, a crucial element in this equation is “invisible” transaction costs — those related to exchanging perceived price advantages for perceived time advantages.

Treynor’s wide-ranging contributions at the FAJ, and later at Q Group and elsewhere, helped to more widely circulate new ideas about the use of quantitative techniques among skeptical investment professionals. Treynor served as editor of the FAJ from 1969 to 1981 and was a regular contributor until the mid 1990s. Many of the articles he authored there are now freely accessible.

In the end, the greatest barrier to the acceptance of novel concepts or techniques, especially those involving mathematical language that many find tedious, is human prejudice. In any organization, people with irrational prejudices will surround themselves with like-minded acolytes. Educational frameworks, professional customs, and institutional and regulatory structures will always lag behind new intellectual insights. So the gradual incorporation of innovations, such as quantitative techniques into the investment profession, even if now it appears a linear triumph, was hindered by many obstacles that Jack L. Treynor did much to overcome.

Further CFA Institute Reading

• “In Memoriam: The Collected Works of Jack Treynor“: This collection highlights some of Treynor’s most insightful and impactful writings for CFA Institute.
• “Measures of Risk-Adjusted Return: Let’s Not Forget Treynor and Jensen“: The Treynor ratio and Jensen’s alpha are risk-adjusted performance measures that isolate the portion of a portfolio’s return explained by its sensitivity to market risk, Deborah Kidd, CFA, wrote. Practitioners who use these measures should understand how the exclusion of idiosyncratic risk and the limitations of beta affect the interpretation of the metrics.
• “Long-Term Investing“: When one talks about market efficiency, Treynor wrote, it is important to distinguish between ideas whose implications are obvious and consequently travel quickly and ideas that require reflection, judgment, and special expertise for their evaluation and consequently travel slowly. The second kind of idea rather than the obvious, hence quickly discounted insight relating to “long-term” business developments is the only meaningful basis for “long-term investing.”
• “The Only Game in Town:” Under the pseudonym Walter Bagehot, Treynor observed that investors persist in trading despite their dismal long-run trading record partly because they are seduced by the argument that because prices are as likely to go up as down (or as likely to go down as up), trading based on purely random selection rules will produce neutral performance; therefore, trading based on any germ of an idea, any clue or hunch, will result in a performance better than neutral. Apparently this idea is alluring; nonetheless it is wrong.
• “Types and Motivations of Market Participants“: The most meaningful measure of performance for active portfolios is not total return but the increment in return that results from trading, Treynor wrote. A crucial element in this equation is “invisible” transaction costs — those related to exchanging perceived price advantages for perceived time advantages (or vice versa).

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.