TREYNOR INTERVIEW
On June 15, 2008
(Edited for clarity and readability)
Steve Buser:
My name is Steve Buser, and on behalf of the American Finance
Association, I welcome you to the latest in a series of interviews
with founding contributors to the academic field of finance.
The series is sponsored by the American Finance Association and,
as with prior interviews, we are thankful for technical support
provided by Dimensional Fund Advisors.
Today’s founding contributor is Jack Treynor. Jack and his wife,
Betsy, have graciously invited us into their lovely home in Palos
Verdes, California for today’s taping.
Jack Treynor continues to add to a remarkable collection of papers.
Based on those papers, those of us in the academic community
regard him as one of us. However, Jack Treynor actually spent
most of his professional life in the real world. Hence, practitioners
lay claim to him as well.
In addition to serving on a number of boards and holding a variety
of positions in the investment industry, Jack Treynor has received
numerous awards including the Nicholas Molodovsky Award, the
James R. Vertin Award, the EBRI Lillywhite Award, the Roger F.
Murray Prize, two Graham and Dodd plaques, plus four Graham
and Dodd Scrolls for Excellence. Jack Treynor also has been
recognized as a Distinguished Fellow by the Institute for
Quantitative Research and Finance.
So how are we to describe a man of such great and varied
accomplishments? Is Jack Treynor a practitioner for whom the
normal rigors of academia are simply a hobby? Is Jack Treynor
truly an academic who somehow managed to not just live but to
thrive outside the ivory tower? Or is Jack Treynor his own unique
brand of hybrid?
I confess that I do not know the answer. Nevertheless, I am
delighted by the prospect of finding out more about this
remarkable person whom I can only describe and introduce to you
as Jack Treynor.
Jack Treynor:
Well, thank you, Steve. I got off fairly easy with that introduction
which was very generous.
Steve Buser:
You earned all of it, and if any of it is not true, we can edit it.
Why don’t you tell us a little bit about how you moved here?
Jack Treynor:
Twenty-five years ago, my partner pushed me out of a firm in
Chicago.
Steve Buser:
Was that Arbit?
Jack Treynor:
Yes. That was Arbit, who I guess is still living somewhere in the
San Francisco area. I was under four years of a non-compete
agreement, and I couldn’t manage any kind of assets for any kind
of client. Then I wrote a play, which in fact won a prize. It wasn’t
much of a prize for sure, but it was produced by CSU Fullerton.
They had a drama department out there, and so they produced it in
a way that was very disappointing to me, but, hey, it got done.
Steve Buser:
How did they even find out about it?
Jack Treynor:
It must have been some kind of competition. It probably worked
this way. I took advantage of the chance to study playwriting at
South Coast Repertory, which produced some really good stuff. I
mean not just my stuff, but really professional stuff. I think
probably that’s where I got tipped off to this competition. So if
they gave another course, I might go the trouble to drive all the
way down there with Betsy and drive back.
Steve Buser:
What made you think you could write a play?
Jack Treynor:
That’s a good question. I wanted to say something and the play
was a way to say it.
Steve Buser:
About portfolio selection?
Jack Treynor:
It was about the Kennedy assassination.
Steve Buser:
I learned this morning from Betsy that that was one of your
interests.
Jack Treynor:
Yeah. I felt that he was assassinated because the family broke a
promise, basically, which was that if the mob helped in Illinois that
when Jack became president he would secure Cuba for the mob.
Steve Buser:
A specific promise to them, not just a generic promise?
Jack Treynor:
That’s right, a very specific promise. It’s hard now to go back to
1962 or ’61 and realize how inconsequential Las Vegas was then.
Steve Buser:
I remember because I visited it, but it was nothing.
Jack Treynor:
It was nothing. Okay, you understand. So Cuba was terribly
important to the mob, Havana specifically.
Steve Buser:
Yeah, that was action.
Jack Treynor:
So that was the deal. We know that Illinois is shaky, and we’ll
secure Illinois. We can do that. We’ll use some names from the
graveyard. Then, of course, came the Bay of Pigs. They used
military people who were not Americans. They were not U.S., and
why? Then the failure. Then the missile crisis, and then the deal I guess it was between Kruschef and Kennedy, saying, “Hey, you
know, we’ll remove our missiles from Turkey, or wherever, if you
guys take your missiles out of Cuba.”
Part of the deal was that we will never again attempt regime
change in Cuba, and the mob just said, "Nuts.”
Steve Buser:
Changing subjects, how and where did you grow up?
Jack Treynor:
Council Bluffs, Iowa, a town which now has to be viewed as a
suburb of Omaha, just across the Missouri River. My vague
impression - of course, it’s a long time since I’ve really been back is that the world is passing Council Bluffs by. It’s just that nothing
is happening there. There are no really exciting industries, and
they are not growing.
But, anyway, when I grew up, Council Bluffs was a town of about
30,000 people. It's a little bigger now but not much. There are two
high schools, Abraham Lincoln and Thomas Jefferson. I went to
AL, and I think I probably worked harder than my average
classmate.
There were about 250 in my class in high school. My first fulltime job was as a busboy in the Hotel Chieftain which was the only
really consequential hotel in Council Bluffs. Twelve hours a day, I
think it was, seven days a week.
Steve Buser:
How much did you make? Do you remember?
Jack Treynor:
Yeah, it was a dollar a day. Seven dollars a week, and the first day
on the job one of the waitresses, a cute brunette, accused me of
stealing the tips off her tables. That was kind of my baptism of
fire. I was so small then – I was only five feet tall – that I didn’t fit
in the busboy’s uniform. So they had to roll the pants way up.
Unfortunately, coming down from a conference luncheon on the
floor above the actual restaurant, I planted one foot in the cuff of
the other foot while carrying a tray full of hotel crockery, and it
was spectacular.
I was told that a number of customers in the restaurant down below
jumped out of their seats. The stairway was one of those concrete
stairways, and it was loud.
Steve Buser:
How about your early academic interests? Did you have special
subjects you liked?
Jack Treynor:
Yes, physics, very much.
Steve Buser:
How early were you introduced to physics?
Jack Treynor:
I think not until I was a junior in high school. I found that I
couldn’t prove many of the formulas in the physics book and
basically the reason was that all I had with which to prove them
was trig and high school algebra.
Steve Buser:
You didn’t have calculus?
Jack Treynor:
I didn’t have calculus, and none of my math teachers had had
calculus. It’s hard to believe now because they teach calculus in
high school routinely. So I invented a crude finite difference kind
of calculus.
I was also on the debating team, and I went out for football when I
was a senior. I had started school when I was four, and then I had
been skipped. So although I never thought about it, I was probably
a year younger than my classmates all the way through high
school.
And, of course, in those years a year can make a lot of difference
in terms of your physical maturity. So I was a very unsuccessful
football player in that one year.
Steve Buser:
What position did you play?
Jack Treynor:
I thought that I’d be very talented at what was then called end and
is now called wide receiver. I was mistaken about that, and I still
have broken fingers to show for it.
Steve Buser:
That's sports. So, how did someone from the Midwest end up in
college on the east coast at Haverford?
Jack Treynor:
This was my parents’ decision. I didn’t have anything to do with
the decision. There was an application to Harvard, and Harvard
offered me a scholarship. But, the feeling on my parents’ part, I
guess, was that Haverford would be a better experience for me. I
think they were probably right about that.
Harvard would have been so competitive. I could have worked
for the Crimson. I could have worked for the debating team. I
could have worked for the drama society or something like that.
But I could only do one thing at Harvard.
At Haverford, I played football. I got my growth finally. I
wrestled, but not very well. I represented my class in the 175pound class on class day when the seniors and juniors competed
with each other at all kinds of different things, and I lost. I was
president of the debating society. I was in the glee club. I was not
very good, but the club was big enough that it didn’t matter too
much that Treynor didn’t sing very well.
I majored in math. I would have majored in physics, which I
preferred, but the physics department at Haverford at that time
consisted of two people, one who was about to retire, Dick Sutton,
and the other, who was much younger and much more vital, but
was absolutely blind. For example, when he went to the
blackboard to write a formula, he would start like this, (motioning)
and then he would write with the other finger back here, so he
oriented himself. He knew where he was on the blackboard by
fixing this finger on the blackboard. I just felt that this was not a
strong department.
So I majored in math, but the stuff they taught was really not what
I would have chosen to teach me; no probability, no statistics, no
regression model.
Steve Buser:
At the time, did you appreciate that you were missing those things,
or did you just think you might be missing something?
Jack Treynor:
I only appreciated that when I got to Harvard Business School, and
I really didn’t get that stuff there either. Later they had Raiffa,
Bob Schlaiffer and Art Schleifer. They taught some wonderful
statistics stuff. But then, no. One day I went back after I
graduated, I went up to Baker Library. I found a book on
probability, and I taught myself.
Steve Buser:
That sounds similar to Harry Markowitz’s story, going over to the
library, pulling books of the shelf and doing it yourself. It's a hard
way to learn the material.
Jack Treynor:
Yeah.
Steve Buser:
You mentioned that you went back to Harvard for your MBA. Can
you tell us more about that experience?
Jack Treynor:
My class at Harvard Business School preceded the GMAT. So
admission was based on an interview with a dean and the assistant
dean. One thing I remember about the interview was he was
testing some kind of psychological property in me because there
was a pencil on the corner of his desk, and he pushed it off. I
leaned over and put it back on the corner, and he pushed it off
again. I leaned over and put it back on the desk. The third he
pushed it off, I just left it on the floor. What that proved to him, I
still don’t know. But in the course of the interview, he said, “Here,
we teach you to think.” I thought to myself, and fortunately I did
not say it out loud, “What arrogance.” But he was right. They
were teaching a kind of thinking that I didn’t know anything about.
This had a lot to do with how I would answer your question about
my ambitions, because I could see, especially in the first year, that
there were guys in my section who were much better at doing what
Harvard Business School valued than I was, a lot better. I had a lot
of ground to make up.
Steve Buser:
After you graduated from Harvard and started your professional
life, you had a number of mentors, both academic and on the
practitioner side. Starting first on the academic side, who do you
regard as your earliest and strongest academic mentors that pointed
you in the direction you ended up taking in terms of all your
articles that you have written?
Jack Treynor:
When I graduated from Harvard, three of my professors asked me
to stay on and write cases for them. I chose Bob Anthony and he
was a fine mentor. He was very patient with me, forgiving of my
mistakes, and just a fine boss.
I took the job with the understanding that I would only work for
him for a year. Then I would go on, and at the end of the year, he
and I both thought that the now-bankrupt and defunct Arthur D.
Little would be a good place for me.
I went to work in the operations research department, and some of
the senior people there were very interesting to me. Les Peck, for
example, had been the resident mathematician at Los Alamos. He
ran seminars in computer programming. He taught us how to
flowchart and that sort of thing.
George Kimball was the junior author of the first book on
operations research, Morse and Kimball. George had a wonderful
mind. His secretary, it turned out, was Betsy’s best friend. None
of us knew that at the time.
Arthur Brown, a Rhodes Scholar, taught me a lot of good practical
things about how to write up technical stuff and things like that, so
there were a lot of teachers there. There was a lot to learn.
Steve Buser:
That was a good environment for you?
Jack Treynor:
A good environment, yeah.
Steve Buser:
You mentioned that in high school you didn’t have calculus, so
you had to invent a kind of surrogate calculus. Did that specific
invention help you down the line or did it just get you through high
school?
Jack Treynor:
I don’t know how far back the use of the SAT goes. Obviously, it
preceded the invention and use of things like the GMAT, but when
I graduated from high school, they were using the SAT.
Steve Buser:
And what year was this?
Jack Treynor:
Nineteen forty-seven.
Steve Buser:
That’s the year I was born, by the way, a very good year.
(Laughter)
Jack Treynor:
Clearly. (Laughter) I’ll never forget that after a day of taking the
SAT my vision was fuzzy for the first time in my life. I had
worked so hard and concentrated so hard that day. I got a very
generous offer from the University of Iowa based on the SAT.
I got the Harvard thing, but it didn’t actually get me any special
financial consideration at Haverford. I took all the math I could. I
took physics and chemistry. I didn’t take biology even though my
father was a doctor. He did involve me in one of his operations. It
was one that required a head-holder, and my job was to hold the
head of the patient while my father operated on the head and I got
pretty queasy. I think my dad decided I probably wasn’t cut out
for that kind of work.
Steve Buser:
How old were you at this point?
Jack Treynor:
Seventeen or sixteen. The math problem I was actually trying to
solve with the calculus thing was called the Towers of Hanoi. I’ve
always liked calculus. I like differential equations. I like partial
differential equations. Obviously, in working on something like
the CAPM, that is not enough. You have to have matrix algebra, I
think, to even conceptually think about a problem like that. So I
was fortunate that I had that. But in college I had, as I say, some
weird things including the mathematics of the theory of relativity.
I never had any use for that material, but it was beautiful.
Steve Buser:
You mentioned your work on the CAPM. Is that how you refer to
it now? I mean, that language was not around when you worked
on it.
Jack Treynor:
Right. It wasn’t around then. My folks had a little place in the
mountains above Denver where they would retreat from the heat of
the Iowa summer and because I was still a bachelor, I would go out
there every summer and spend my annual vacation with them.
And in 1958, I went down to the University of Denver Library and
read Modigliani and Miller’s 1958 paper arguing that basically aside from tax considerations - changing the degree of levering in a
company’s capital structure will not change the value of the
company. It won’t change the cost of capital.
Steve Buser:
You say you went into town to read that article. Did you know
about the article?
Jack Treynor:
Yeah, somehow I knew about the article. I don't know how I
knew, why I went down to the University of Denver Library, or
what tipped me off to this wonderful M&M paper. I just don’t
know now. But it was inspiring.
Steve Buser:
You continued down that road. You were looking for – correct me
if I’m wrong – if not a solution for the discount problem, at least
how do you choose a rate of discount for evaluating projects or
evaluating assets.
Jack Treynor:
My teachers at Harvard Business School, basically, they told me
two things. One was that every corporation had a kind of a
characteristic internal rate of return. The other thing they told me
was that when you were dealing with a specific project, you took
the risk of that project into account. That seemed to me to be a
very unsatisfactory answer. It seemed to me that if you’re talking
about building a new factory or something like that with a
projected life of 30 or 40 years that a change of 1 percent in the
discount rate would probably make a huge difference in the present
value, large in relation to the initial cost.
It didn’t then occur to me that this might be a good thing and that
an ambitious, young finance type might take advantage of that very
fact to make sure that the comparison between present value and
cost came out the way his bosses wanted it to come out.
Steve Buser:
Sticking with that topic, with your original contribution that we
now think of as the Capital Asset Pricing Model, I also understand
that originally it was part of a larger paper. Is that correct? If so,
could you give us that history?
Jack Treynor:
My idea was that I would try to solve the problem for a short time
interval, like a year. Then I would take that result and drive it to
the instantaneous interval. At that point, I expected to have
essentially a partial differential equation that I would integrate out
over a long time period like 30 or 40 years to figure out how the
risk would be changing over time and how the discount rate would
be changing over time. That was the idea.
Steve Buser:
Were you going to let the interest rate vary over time as well or
was the interest rate going to be fixed?
Jack Treynor:
I’m sure I was going to keep the riskless rate fixed.
Steve Buser:
Okay. It was still an extremely ambitious project.
Jack Treynor:
Of course, Franco Modigliani did me a huge favor by saying,
“Look, Treynor, break this thing up into two pieces.” He called
the first piece “Toward a Theory of the Market Value of Risky
Assets.” It was funny because the title has a wonderful social
science flavor about it that Treynor would never have used. I don’t
know what I would have called it, but it would not have been that.
Steve Buser:
The intriguing result that now we take for granted in finance is that
the appropriate measure of risk is covariance between a particular
asset and the general market. Did you see that result coming
before you wrote the paper, or did it pop out at you and even shock
you when you discovered that?
Jack Treynor:
I absolutely did not see it coming. I think the Harvard Business
School orientation at that time, a naïve expectation would have
been that maybe variance would have something to do with it, but
covariance? Holy smoke.
Steve Buser:
Well, that may explain the next puzzle. On page 20 of the paper
that went unpublished for many years, it strikes me that you are
almost apologetic with respect to your finding. I’d like to read it to
you and then let you react to it with the advantage of time. It says,
“Apparently, it is a mistake to expect the risk premium to depend
only on the sheer magnitude of the risk. If the uncertainty in the
stock is small, or if the uncertainty is not small but orthogonal to
the market as a whole, then the risk premium will be small.” That
phrase, “Apparently, it is a mistake” did you mean to be hedging
your bets there? Or am I reading too much into that phrase?
Jack Treynor:
Well, I’m surprised I said that. I was certainly more articulate then
than I am now, but it sounds as if I was a little nervous.
Steve Buser:
So you felt more strongly in the result than that phrase would
indicate.
Jack Treynor:
Well, I sound as if I felt that my Harvard Business School
professors were looking over my shoulder.
Steve Buser:
In my experience teaching this material, we always follow up this
statement with a quasi-arbitrage argument. For example, if people
were pricing total risk and therefore required a large premium for a
project that was largely orthogonal with the market, other investors
would jump on it. Did you have any intuition about that type of
market discipline on this structure at this point in time?
Jack Treynor:
Probably not.
Steve Buser:
The reason I asked, and perhaps I gave you too much credit at the
time, was that within a relatively few years, you came up with the
arbitrage argument in your paper with Fischer Black on how to use
security analysis to improve portfolio selection. Specifically you
showed what to do if you thought you could do a little better than
the Capital Asset Pricing Model would predict. If you found what
we now think of as a positive alpha investment, you would buy the
asset, but only up to certain amount based on what you called the
insurable risk. Others would give it other names, like diversifiable
risk, but there would be any number of people jumping on this
asset. When did that perspective enter your mind?
Jack Treynor:
Wow. I don’t know when Jim Lorie’s CRSP seminar started. I
would like to think I got involved pretty close to the beginning of
it. For me, it was very stimulating and provocative talking to Larry
Fisher, Jim Lorie, and, of course, Gene Fama. He was there fairly
early on, and Jim Lorie was bringing in a really exciting bunch of
people to talk to that seminar in addition to those great members of
the Chicago faculty. I suspect that was pretty provocative.
Steve Buser:
You mentioned some early stars in the profession. Did you bounce
any of your ideas off of them? You mentioned that seminar. Did
you present your paper at that seminar, for instance?
Jack Treynor:
Yes. Fischer Black and I presented it in 1967. Then we submitted
it the Journal of Business. They said, and you will understand
their response, “This can’t possibly be right because everybody
knows that all investors have the same information and that there is
no potential for advantage.”
Maybe this is unfair, but I now think that is part of this efficient
markets philosophy which, of course, is very helpful and powerful
in thinking about a lot of problems. So they rejected the paper.
Steve Buser:
If it is any consolation, Bill Sharpe tells the story that his paper on
the Capital Asset Pricing Model was rejected for precisely the
opposite reason. He had assumed, as you did in “Towards a
Theory of Market Value”, that …
Jack Treynor:
Everybody had the same information?
Steve Buser:
Yes, everybody had the same information. They thought that was
preposterous. So it’s preposterous to have the same information or
to have different information. Both are preposterous. Welcome to
academics. We are capable of some rather spectacular
inconsistencies.
I probably should have stuck with your CAPM paper a little bit
longer because it also had a very interesting history and never did
get published. While you were working on that, you circulated it
to a number of very important people. Bill Sharpe says that he
received a copy at one point, and I believe John Lintner received a
copy. What do you remember about the details of how your paper
made the rounds after Franco had split into two, and now we are
talking about just your CAPM paper floating around?
Jack Treynor:
Well, one very strange thing happened. Arthur D. Little had hired
a Ph.D. economist from Chicago for the operations research group.
Without my knowing, he sent the early paper to Merton Miller.
Franco was just leaving Northwestern for MIT. Sometime after he
got to MIT, Franco called me up at Arthur Little and invited me to
lunch and he said, “I’ve read your paper. Frankly, you need to
come to MIT and study economics.”
Steve Buser:
Typical Franco. (Laughter)
Jack Treynor:
I didn’t even ask my boss’ permission. I didn’t even say, “Hey,
would it be okay if I took a year off and would that be in your
interest or not?” No, I just went.
Steve Buser:
It was right next door, was it not?
Jack Treynor:
Yeah, and Franco laid out my courses. He chose my teachers,
basically. Of course, one of the courses he assigned me was his
course on capital theory, but he also included a course on
econometrics. That was my first exposure, for heaven’s sake, to
the regression model.
When I finished that year with MIT, I went back to Arthur Little.
The boss called me in on the first day I was back, and he said,
“Does any of this stuff that you’ve been doing have any
commercial value at all?” I said, “Boss, let me think about that for
a couple of days, and I’ll come back to you with a list.” I came
back to him with a list, and Martin Ernst went down that list, and
he stopped at performance measurement. He said, “Show me that
you can do something useful with performance measurement.” I
said, “Okay,” and I came back a couple of days later with an
approach that became the first Harvard Business Review article.
Steve Buser:
That was a blockbuster, as was the second paper. You had two on
that topic. You were responding to your boss, and then you
published it. But did you think you would be setting the tone for
an entire industry at that point?
Jack Treynor:
No.
Steve Buser:
Just getting the boss off your back?
Jack Treynor:
With one caveat. It led to some work for the treasurer of Yale. He
was managing the endowment out of his hip pocket, so to speak.
He had all kinds of other responsibilities for seeing that money was
properly and responsibly spent by all the departments in the
university. But he was taking a very casual approach to managing
the endowment, and a number of Yale alumni said, “That’s
absolutely wrong. Here is an example of what a real pro could do
with the Yale endowment.” The pro they had in mind was a guy
they called “The Chinaman,” 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.
Steve Buser:
I can imagine.
Jack Treynor:
So with that exception.
Steve Buser:
When you were thinking about performance measurement, were
you thinking of evaluating an entire portfolio, or were you thinking
about evaluating a manager who might contribute to an entire
portfolio? Or did you even make that distinction at that particular
point in time?
Jack Treynor:
I wasn’t making that distinction. As you well know, TreynorBlack basically defines a thing called the “information coefficient”
and gives you a framework for evaluating people who are
managing sub-portfolios and stuff like that.
Steve Buser:
You have anticipated my next question. Have you ever heard of
anyone else evaluating managers using your information ratio or
your appraisal ratio method?
Jack Treynor:
Somebody else should have judged it subjectively, but Walter
Good, whom I invited to join the editorial board at the Financial
Analysts Journal, and who was basically the chief investment
officer at Lionel Edie, wrote a book with Jack Meyer, who is now
better known than he was when he was Walter Good’s protégé at
Lionel Edie. I believe it uses this framework.
Steve Buser:
Good, because when I taught the material, and if you forgive me
this little bit of a speech here, when I first started teaching I taught
Markowitz’ analysis which elegant but intractable for most
students, particularly business students. We were never going to
estimate all these variances and covariances, and we didn't even
have a computer to solve the problem. It’s elegant mathematically,
but they thought it was useless. Then we had your paper, Sharpe’s
paper and Lintner’s paper on the Capital Asset Pricing Model
which said, “Well, there’s a version of the portfolio problem that is
trivial. You just hold the market passively.” That didn’t excite the
MBAs either. They said, “We are not going to make a living doing
this.” Then along came your paper and it said, “We can have our
cake and eat it, too. It can be elegant and practical. One very
simple ratio will tell you how to run your business and evaluate
your business.”
I told people, “Aha. This is the paper that will set the standard for
the industry for the next generation.” But as far as I could tell it
almost never made any impact out there. I don’t know anyone that
even reports the residual variance.
They’ll estimate beta. There are many beta services out there, but I
never found one service that would estimate the residual variance,
the denominator for the Treynor-Black information ratio, to tell us
say, “How much money should I put with Dimensional Fund
Advisors?” It was very frustrating to me as a teacher, and I never
understood it. Did it make to you that that it would not be getting
more play even today? But you say at least one person did it.
Jack Treynor:
I guess I was surprised. I just wrote a case in which I try to
suggest to the reader that when you are comparing alphas of
different portfolio managers, it might be useful to look at turnover
rates because that is a real simple concept. And I notice that some
of the annual reports of mutual funds actually report the history of
turnover rates which suggests to me that maybe the SEC is
requiring them to publish those turnover rates.
I mean that is a real easy thing to use. It doesn’t take an expert
statistician to adjust alpha, because if you double your turnover
rate and do not change anything else, but just use the same
research advice and buy the same stocks but double your bids, you
will double your alpha, except for effect on trading costs. So why
not adjust alpha for turnover rate?
Steve Buser:
It hasn’t happened?
Jack Treynor:
Hasn’t happened.
Steve Buser:
All right, well, I thought perhaps I just was not tuned in enough. I
am retired now. But I had been telling students for close to 30
years to watch for this big innovation in the industry.
How about another potential application of the Treynor-Black
model for determining a required rate of return for required overweightings. For example, if you are going into a private equity
deal or starting your own business, you are deliberately taking
much more of this position than the market weight. Do people
either intuitively or practically think of the insurable risk or
diversifiable risk that they are putting in their portfolios and
formally translate that into a required rate of return? Or are we
still back pre-capital asset pricing days with Harvard Business
School thinking that there is probably some kind of a tradeoff?
We’ll throw in a few points and require a 30 percent rate of return
rather than a 20 but no precision there. Where are we on that scale
from industry’s point of view?
Jack Treynor:
I think you are right. We are still way back there. One of the
problems with the CAPM, which I’m sure you appreciate, is in
trying to find practical applications. For example, in the U.S.
market the standard deviation of one year’s rate of return is about
20 percent. Now you say, “Well, fine. I want to measure the
average market premium. So how long of a time sample do I need
to get the standard error of my estimate down to, say, 1 percent?”
You need 20 squared years.
Steve Buser:
We’re still counting. (Laughter)
Jack Treynor:
Okay. And I think there are other ways, as you also know, to get
around this somewhat, but I think this is a bit of a problem.
Steve Buser:
I have one more question. I apologize, but your side bet paper
with Fischer is one of my all-time personal favorites, and the other
part the puzzle is the Black piece. What did Fischer Black add to
or contribute to this work? Do you recall the division of labor
between the two of you?
Jack Treynor:
Oh, wow. I really don’t. It’s so far back now. I’m sure he
contributed a lot.
Steve Buser:
That’s okay. You mentioned that two people who were influential
in your life were Franco and Fischer. Can you tell us anything
more about how those initial meetings took place?
Jack Treynor:
Franco, of course, impressed me as brilliant, along with Howard
Raiffa and Harry Markowitz. These are the three people that I
happened to know in my career who just had outstanding
intelligence who just made me feel about that big. Bill Sharpe is
very bright. Bob Merton is obviously very bright. There are lots
of bright people in finance, as you well know, but those three guys
are really something.
Steve Buser:
What were your first impressions of Fischer Black when you met
him, and how did you meet?
Jack Treynor:
My recollection is that Fischer came to Arthur D. Little in 1965.
There were about 60-odd professionals in that operations research
group. I think it’s fair to say that really none of them, including
my boss, were interested in my work. They had a lot of other
things to be interested in, such as inventory control and
forecasting. But Fischer, for some reason, took an interest. I guess
he came around and introduced himself, and he took an interest.
Almost immediately it became more than just a professional thing.
At the time, Fischer was taking care of his girlfriend who had one
of the incurable wasting diseases. I don’t know if it was Lou
Gehrig's disease or what, but she did not want to go home to die.
So Fischer was basically doing two fulltime jobs. He was working
for Little, and trying to establish himself there, and he was
basically her nurse. She was living with him, and I would go over
and meet her and Fischer
I am not sure how Fischer got involved with CRSP, but I think he
was probably involved before that 1967 joint presentation. As you
know, he had a doctorate’s degree in what I’ll call applied math
from Harvard. But he had a lot of curiosity about the world and
how things really worked.
Steve Buser:
Did the two of you click immediately or did it take some time for
you to get to know each other?
Jack Treynor:
I don’t think it took very long. He was, well, the word “quant”
really has two different meanings. One is for people who are only
interested in numbers. They really don’t care very much about
going beyond numbers into the real world. The other meaning is
for people who care about finding better quantitative ways of
structuring the real world. They are more realistic, and so on.
Fischer was the second kind of quant.
Steve Buser:
Your two papers in the Harvard Business Review came out right
after your contribution on the Capital Asset Pricing Model. Can
you distinguish between those two papers? For example, what
were you trying to accomplish with the first paper?
Jack Treynor:
In the first paper, I was trying to introduce what I then thought was
a new concept of performance that was not just rate of return.
Performance was rate of return with the market effect subtracted,
for good or for ill.
Steve Buser:
You did not use the term “Treynor Index” at that point in time.
Jack Treynor:
Gosh, no.
Steve Buser:
But that is what we’ve now come to know as the Treynor Index,
correct?
Jack Treynor:
There are some people who say that the Treynor Index has a
denominator which is beta. Our previous conversation would
suggest that if I double my bets, I am going to double my alpha
relative to you for making our bets based on the same research
advice.
I am not going to change my beta. I’m buying the same stocks. I
may be doubling my bets, but the average beta of the stocks I am
buying is going to be the same irrespective of the size of my bets.
So beta is an inappropriate divisor.
Steve Buser:
How would you define the Treynor Index to be historically
correct?
Jack Treynor:
A few months ago I went back and read the old Harvard Business
Review article, which I hadn’t read in years. Basically, it says to
regress the return on the fund in question against the return on the
appropriate market index to find out what the slope of that
regression line is.
Steve Buser:
Do you remember what you called the regression line, by the way?
Jack Treynor:
I didn’t call it beta.
Steve Buser:
No, you called the regression line the characteristic line, though. I
believe you were the first to call it that.
Jack Treynor:
Oh, yeah, you’re right.
Steve Buser:
I didn’t mean to interrupt the story.
Jack Treynor:
I wasn’t smart enough to call the slope beta.
Steve Buser:
Neither was Bill Sharpe. We are not certain who came up with the
word “beta,” but somebody did.
Jack Treynor:
And I didn’t call the residual alpha either.
Steve Buser:
Okay.
Jack Treynor:
I have long thought that basically the term “beta” was invented by
a Harvard Business School professor named Colyer Crum. Now,
this may be very unfair to Colyer. He should be free to defend
himself on this, but my thought was that he dubbed it beta to
suggest that only pointy-headed academics would ever think that
there could possibly be a meaningful measure of risk.
Steve Buser:
(Laughter) So he is going to get credit but in a negative way as
well as a positive way?
Jack Treynor:
Yeah.
Steve Buser:
Well, I still thank him or whoever came up with it.
Jack Treynor:
That was the first piece. The birth of the second piece was a critic
who said, “What you’ve done in this first piece is no good because
funds will be trying to outguess the market, and in doing so, they
will be constantly changing their betas so you won’t be able to get
a meaningful measure when you start looking at the statistics of the
fund.”
My reaction to that was, “Well, if they can successfully outguess
the market, then when the market return is high, they will have a
large beta, and when the market return is low or negative, they will
have a low beta. That means that the line, instead of being straight,
will be curved. So what we need to do is measure the curvature of
the line.”
Kay Mazuy said, “Look, all you have to do is introduce a squared
term into your fitting function and you can use that to pick up the
curvature.”
Steve Buser:
And what was your finding? Do you recall that?
Jack Treynor:
I think we looked at 40-odd mutual funds and only one showed any
talent at outguessing the market.
Steve Buser:
I believe your paper predated by roughly 15 years a similar finding
by Merton and Hendrickson. Are you familiar with their study?
Jack Treynor:
Those are smart guys, and they are a lot more sophisticated.
Steve Buser:
But they had similar findings using s similar approach. Your
earlier paper also predated a whole avalanche of studies on
performance, and again I think your findings were very similar
findings of Jensen and others.
Jack Treynor:
I think a lot of investors out there today still think that you can
measure trading performance with rate of return. The reason I
think that is that when the overall stock market goes up, trading
volume goes up, and when the stock market goes down, trading
volume goes down. There is a strong correlation between the two.
Steve Buser:
Interesting.
Jack Treynor:
I can’t justify it any other way, but you might think of a better
explanation.
Steve Buser:
Not sitting here. I’ll give it some thought, though, and let you
know if I come up with anything.
Jack Treynor:
Okay.
Steve Buser:
Well, in addition to those works, you have had a number of other
very exciting themes that you’ve written about. I would like to
cover as much of that ground as possible. However, given the
range and scope, it is a difficult task. So I have attempted to make
some classifications. If the classifications are wrong, feel free to
correct me. And if we omit any of your favorite papers by virtue
of this classification, feel free to point that out, and we can talk
about them as well.
I am going to refer to the first category as macroeconomics, which
includes your views on growth theory, the role of money, inflation,
trade deficits and the fiscal burden of government. In the area of
macroeconomics, are there one or more findings that you could
point us to that you personally regard as either the most significant
or that you had the most fun developing, either one?
Jack Treynor:
I owe my interest in macroeconomics to the year with Franco and
MIT. I have been hopelessly schizophrenic ever since. I mean, I
am a Harvard Business School graduate, and I am Franco's student.
I approach macroeconomics with a whole bunch of prejudices,
some of which I can kind of adduce evidence for, but many of
which I can’t.
One of my prejudices is that capital goods are tradable goods.
They don’t have a national or local market. They have a global
market with a global price that reconciles global supply with global
demand.
Steve Buser:
Are you talking about direct markets or indirect markets? Do we
trade the product of the physical plant and equipment or do we
trade the products they produce?
Jack Treynor:
Good question because so many of the products are commodities,
of course, and they are obviously tradables. But I like to think that
the capital goods themselves are also tradables. In some obvious
cases, like oil tank ships for example or airliners, these capital
goods are so portable that they obviously must be tradable goods.
It’s less obvious for machine tools and things like that, but if
capital goods are indeed tradable goods, and if you think, for
example, that Korean, Japanese and German machine tool
manufacturers are competing effectively with American machine
tool manufacturers in the American market, then basically our
country’s trade balance affects its ability to buy capital goods and
therefore its ability to grow through accumulation of capital goods.
Now on the question that you were asking before about the product
of the capital good, in my view, if the country buys capital goods
and uses them to produce a home goods product, they can have a
problem because they can’t improve their trade balance with those
products. Therefore they can’t pay back money that they’ve
borrowed from a rich, mature industrial country that would like to
sell them capital goods.
I think that a common, but in my view unfortunate, practice of
foreign lenders and foreign investors is to use local banks to
determine who gets the money in developing countries. I think this
is very dangerous because local banks aren’t educated to make the
distinction between home goods and tradable goods. They end up
making loans they shouldn’t make, and it will lead to a currency
crisis.
Steve Buser:
Do you think there’s a role for international banking? Is that what
you’re suggesting, sort of broaden the scope?
Jack Treynor:
That’s an interesting idea.
Steve Buser:
My next question is about microeconomics, and again I am
grouping a number of topics together. I am specifically thinking
about your papers on monopoly and competition and various
contributions on the sources of economic value for individual
firms. If we take all of those themes collectively, are there any that
you regard as either particularly exciting or particularly important?
Jack Treynor:
My published paper, “How to Regulate a Monopoly,” has been
ignored about as completely as any paper I ever struggled to write.
It argues that the current practice, which is virtually universal so
far as I know, of regulating monopolies by imposing a limit on the
price they can charge, is the wrong way to do it. Instead of putting
an upper limit on the price monopolies charge, they should put a
lower limit on the output they produce.
Steve Buser:
Would you advise that, for instance, for a local utility that is
granted a local monopoly?
Jack Treynor:
Yes.
Steve Buser:
How about oil companies? Would you have the same view on
that?
Jack Treynor:
I guess not. As you know, to go back to utilities, we now have
something approaching a national grid and the national grid
basically creates a kind of a market for power producers, but as
you were careful to say, it’s the guys who distribute the power
locally, the retail market for power, who have the big monopoly
that needs to be regulated.
Steve Buser:
In particular you are here in California, and you have a very
different local philosophy toward that grid. So while I think we
actually have a grid, my understanding is that we have the grid but
politicians are also involved. So the grid is maybe not as smoothly
functioning as you might like.
Jack Treynor:
I know that from time to time there are shutdowns in important
large markets like New York and maybe Los Angeles. I shouldn’t
point too many critical fingers at New York.
Steve Buser:
But rarely does it spill over to Columbus, Ohio, for example, so the
grid is protected by bureaucrats. (Laughter)
Jack Treynor:
Okay, or Council Bluffs, Iowa.
Steve Buser:
Or Council Bluffs. Well, those who are generally familiar with
your most important works might be surprised that there is a
version of Jack Treynor who is apparently a would-be accountant.
And so I’m going to ask if you can summarize your views for us
on the appropriate role for specifically financial reporting. You
have a couple papers in this area as well.
Jack Treynor:
Basically, as you know, double entry bookkeeping goes back to
Luca Pacioli. It is a very clever system, and it was designed to
give a very ambitious set of answers at a time when there were
probably no other financial professionals around to give people
advice about investments, or projects, or buying companies, and so
on.
The problem, in my view, is basically that earnings attempt to
measure the change in the value of a firm over the accounting
period. And as I argued in one paper called “The Trouble with
Earnings,” if that is in fact what we want to accomplish with
accounting, then logically security analysis should precede
accounting rather than follow it. Accountants really need security
analysts’ estimates of the value of the important fixed assets in a
company before they can calculate a meaningful measure of the
change in the value of the company over the accounting period.
To me, a much more appealing number for public companies to
report to investors is something like operating cash flow. I'm not
particularly original in liking this number. I think there are a lot of
thoughtful people, like Al Rappaport and Michael Mauboussin,
who know a lot more about accounting than I do, but it seems to
me this is a lot closer to what investors really want and need.
Steve Buser:
So you would not advise spending a whole lot of time or effort in
mark-to-market accounting for various asset classes or even
intangibles, things that maybe don’t even show up on the books.
Jack Treynor:
I would not object to marking inventories to market. I can see
there are potential problems with doing that, but I think there is a
better compromise than the present.
Steve Buser:
Gotcha. Turning now to your interests in corporate capital
structure, it obviously predates your association with Fischer
Black, yet your published work on topics such as pension finance
and municipal bonds appears to be heavily influenced by Fischer’s
seminal work with Myron Scholes on options pricing theory. Can
you walk us through your development of those ideas both before
you met Fischer and then perhaps the influence of Fischer on you
and any changes in those ideas you might have?
Jack Treynor:
Yeah, I think he had a big influence on me. The idea in Black and
Scholes that basically the value of a risky corporate bond or indeed
any other risky debt claim on a company reflects an option against
the lender, which I guess could be characterized either as a put or a
call depending on which way you want to play the game, is just a
very powerful idea.
Steve Buser:
Do you think it is practical as well as intellectually interesting, that
idea? In your work you seem to assume it is both.
Jack Treynor:
I guess I think it’s practical. Of course, this is a situation where a
specific risk, insurable risk could be important as well as
systematic risk.
Steve Buser:
That was going to be my next question. Given that interest on the
practical side, are you surprised that we are not doing more to
estimate the total risk of projects, or of the underlying assets, that
are the basis for the put or call options in these papers?
Jack Treynor:
I hadn’t thought of that, but I find that argument very persuasive.
Steve Buser:
You have also written extensively in the area of securities trading
or what academics refer to as market microstructure. I suppose
there is an obvious answer, but for the record, how did you get
interested in this area, and what role does that interest play, if any,
in the professional advice you offer to people in need of help with
their money?
Jack Treynor:
The first paper that kind of documented my interest was one that
basically said, “Look, the dealer is going to lose to people who
know things he doesn’t know." It’s just inevitable. They have the
option whether to trade with the dealer or not, but the dealer does
not have the option whether to trade with them. If they know
something powerful about a company, they can take advantage of
the dealer. He is going to lose money on those transactions.
So that early piece argued, “Look, the dealer has got to make
enough money on the people who are not trading on that kind of
information to cover himself on what he loses to the people with
the information." That principle is going to determine dealer
spreads.
Steve Buser:
Staying with that theme, do you see dealers as fundamentally
different beings from investors, such as those in your Capital Asset
Pricing Model where they buy and sell securities until at the
margin they have the same degree of risk aversion and go about
their business investing the same as everyone else? Or are dealers
outside of such models? Some models even regard dealers as risk
neutral people. My students used to ask me, “Well, if they’re risk
neutral, why don’t they buy all the high beta stocks?”
I had no good answer for them. So what is your view of the
dealer? Is the dealer the same as the rest of us? Or is a dealer a
different breed that is off of the equilibrium somehow?
Jack Treynor:
My view of a dealer is that, although I can not lay off my position
to a dealer without his acquiring that position, whether short or
long, the dealer has absolutely no intention of sitting on that
position. He is going to turn around and lay it off to what I call a
counter party. Basically, I have argued that inside information is
really information that gets into the price between the first
transaction and the second.
Steve Buser:
So in your view of dealers, they are not really aggressively taking
long positions or committing to take short positions. They are
essentially zeroed out in their net holdings?
Jack Treynor:
They do not expect to be damaged by information so authoritative
at its source or so unambiguous in its implications for the company
that they can not lay off a position before it hits them or hurts
them. They are just not playing the same game as the rest of us.
Steve Buser:
There are two topics on my list that I admit took me by surprise.
After I read them I understood a little bit more, but the titles took
me by surprise. You have written about pricing bubbles. Can you
summarize your views on pricing bubbles? Do bubbles exist? Are
they a figment of our imagination? Or are they consistent with
some notion of equilibrium?
Jack Treynor:
I should first of all admit to some internal mental inconsistency in
writing papers about bubbles that I can’t resolve. My view of
bubbles is this. The value of the market depends on investors’
opinions. It depends on the opinions of the investors who are
bearish, and it depends on the opinions who are bullish. It also
depends on the clout that these investors have in the market. And
in fact, it depends on their equity, the wealth of these investors.
The problem is that when the market level changes, wealth shifts
from the bulls to the bears or from the bears to the bulls, depending
on the direction of the change.
If you believe that the proper market level depends on the wealth
of the bulls and the bears, it seemed to me that you have to
recognize that there is a second stage effect of that original change
in market level that takes into account not only the change in
opinions but the change in the wealth of the people holding those
opinions.
Steve Buser:
Is it fair to say that this has the flavor of a notion you originally
presented to Franco many, many years ago, where you had an idea
for a one-period cross-section for your capital asset pricing model,
for example, but that over time that there can be changes in that
pattern, and this is the time dimension?
Here you are saying there is an interaction. As wealth gets
redistributed, we may observe changes in the parameters of the
Capital Asset Pricing Model, for example. Is that what we are
picking up here is that interaction of the two papers?
Jack Treynor:
I hadn’t thought of it that way, but that’s an interesting way to
think of it.
Steve Buser:
Well, apparently I didn’t guess well, but that is what I thought you
were ______.
Jack Treynor:
I was driving at, yeah.
Steve Buser:
You also have a paper in defense of technical analysis. I doubt
very many technical analysts would see it as a defense of their
particular technical analysis, but you do offer a defense of certain
types of technical analysis. Can you summarize that for us?
Jack Treynor:
Wow, in that paper with Bob Ferguson, I think basically what it
was trying to do was use statistics to try to get some sense of what
the pattern of price change was telling us, and I really should be
more knowledgeable on it because I went back and looked at that
paper recently, but -
Steve Buser:
That is one of the disadvantages of having done so much work It
is hard to stay on top of all it. So don’t worry about that one or any
of these that you’re a little fuzzy on. That’s quite all right. It’s to
be expected.
Following a break in the taping
Steve Buser:
During the break, you mentioned that you have a Samuelson story
for us. Are you willing to share that?
Jack Treynor:
When I was at MIT, Milton Friedman was invited to give a talk at
MIT. I assume now many years later that he was talking about
Friedman and Schwartz, which was published just about the same
time I was at MIT. The presentation was held in a classroom with
an aisle down the middle running up to the front. Of course, the
blackboard is at the front, and there was an empty seat in front of
me.
Friedman started to talk, just kind of preliminaries, and the door at
the back of the classroom burst open. Samuelson ran down the
aisle and sat down in this vacant chair right in front of me. As
Friedman continued to talk, Samuelson’s neck turned pink.
As Friedman continued to talk, Samuelson’s neck turned red, and
finally, as Friedman continued to talk, Samuelson jumped up
before Friedman had completed his presentation and ran out of the
room just as fast as he had run in. So that is my Samuelson story.
Steve Buser:
That was probably Samuelson on good behavior because Friedman
was a guest.
Jack Treynor:
Because he is pretty vocal about his opinions.
Steve Buser:
That’s right. And they had a tremendous running debate for many
years. I was sorry to see Milton Friedman pass on.
Another one of the themes in your work is on agency theory and
shareholders. My question is to what extent do you believe it is
reasonable for shareholders in widely held corporations to believe
that it is being managed in their interests as opposed to primarily
the interests of the managers with the shareholders kind of as an
afterthought?
Jack Treynor:
My empirical observation, fairly casual and fairly limited sample,
is that when someone like the Sage of Omaha, Warren Buffett,
goes into the market and buys my stock at a price that reflects the
fact that I don’t have any control over the company in question,
and then he goes around and buys your stock and stock of
everybody else in the room here and he puts together an
aggregation that is large enough to control the company, he has
something more valuable than I had.
My casual observation is that when control is sold, it is worth
about 40 percent more than the company was worth to little
investors like me. Now that’s substantial.
Almost every day in the financial pages of the newspapers we read
these admittedly liberal reporters’ complaints about what the top
executives of the big companies are getting. The complaint is
always that their services to the company couldn’t possibly be
worth that much. Of course, these reporters are steadfastly missing
the point that, although they get it in a lot of different forms
including salary and pensions and so on, this is not salary. This is
not simply payment for their services to the company. This
includes payment for the value of control, and this is being
overlooked all the time.
Steve Buser:
Are you happy with the current situation? Or do you think that
shareholders need additional aggressive steps from money
managers, pension funds and other large shareholders? Should
there be a more coordinated effort? Or are things working out
pretty well?
Jack Treynor:
I am sorry that Bill Donaldson did not get to perform his
experiment with mutual fund boards. Of course, there are potential
problems with that we could talk about, but that would have been
an interesting test.
Steve Buser:
Another topic on my list of categories is that you have written on
the issue of the optimal or appropriate passive index fund. Again I
was surprised that you appear to be more flexible on this topic than
I would have guessed. Is there an optimal mutual fund out there
for people to use as a proxy for the market portfolio?
Jack Treynor:
Rob Arnott has invented something he calls fundamental
indexation. He claims that his index funds outperform
conventional index funds. He claims the reason, basically, is that
in a conventional index fund, overpriced stocks are over-weighted
and under-priced stocks are under-weighted. That hurts the
performance of what to most of us looks like a strictly neutral bet
on the various stocks in the market.
Arnott says that we don’t have to have this problem with our index
funds. All we have to do is weight the stocks in the fund so that
their weights aren’t correlated with prices. If we start with the
premise that there are errors in the prices, and we use any
weighting scheme that is uncorrelated with the prices, it will be
uncorrelated with the errors.
They may be uncorrelated with a lot of other desirable things, but
that is Arnott’s argument. He claims that he has applied this thing
to a lot of index funds in a lot of different countries and he finds,
quite consistently, the kind of result that he is arguing for.
Steve Buser:
Have you revisited your original CAPM paper with this in mind?
Suppose there are pricing errors that investors are not aware and
you re-derive your equilibrium. Would you pick up this different
index fund, or would you still end up where all shares have to be
held by someone, and if the market portfolio must be held, it has to
be the dominant mix of risky securities?
Jack Treynor:
I think I am compelled to agree with you that the erroneously
priced shares must be held by somebody and not everybody can
benefit from Arnott’s idea.
Steve Buser:
That begs the next question. Are we now in your Treynor-Black
world where there are some potential side bets out there from
mispricing? Unfortunately, people don’t know about them. So
how do we structure a Treynor-Black side bet to take advantage of
what Arnott is picking up as improved portfolio performance on a
risk-adjusted basis? What am I missing in that debate?
Jack Treynor:
Arnott says that with very minor adjustments over time he almost
doesn’t have to trade. It’s not that he’s saying, “Look, the market
is overpricing some stocks and under-pricing others. Let’s go out
there and buy the under-priced stocks and sell the overpriced
stocks and take advantage of this.” He’s saying, “No, I don’t have
to do that. I just let the index funds create their own problem.”
Steve Buser:
So it’s an implicit package of Treynor-Black adjustments and
weights, so he’s got a whole package of those things working.
Jack Treynor:
I wish I’d thought of it.
Steve Buser:
All right. I won’t badger you further on that one. What about
international securities? They are becoming more and more
popular. Yet, as an academic, this is one of the topics I thought
would have been solved a long time ago. In the mythical market
portfolio, we hedge away currency risks. Why is no one providing
hedging services? If I buy a world portfolio that has Chinese
securities in there, why doesn’t it come with short positions in the
Chinese Yuan? Why is it left to me, the individual investor, to
figure out how to short the Yuan which legally I can’t even do?
Why has industry been so slow to provide that element of the
package that we all agree should be there?
Jack Treynor:
Yeah, I think international investing is still very, very backward
and there are just all kinds of opportunities there. As an
economist, it seems to me you have to look at countries and say,
“Boy, the way the government is managing its policies, they’re
really creating a great environment for private enterprise and
growth and investment, and that other country, holy smoke, they
just couldn’t be more hostile to investors.” And do investors really
fully discount for those differences? Do we have a systematic
framework for putting countries into a framework of comparison
and saying, you know, this one is 300 basis points a year better
than that one for the investor who just buys their index funds.
Steve Buser:
So am I hearing from you that even though the securities are out
there, they’re in the marketplace, that there are certain securities
that shouldn’t be in the worldwide market portfolio as a matter of
principle because there are different types of risk? Or am I hearing
that this is a Treynor-Black situation where those should be underweighted because you believe there’s a negative alpha associated
with some type of problem in that country or a third option that
there’s unusual diversifiable risk that you don’t want in your
portfolio?
Jack Treynor:
As you know, there is more diversifiable risk in the global
portfolio than there is in the U.S. portfolio. We ought to be taking
advantage of it. Part of this problem, it seems to me, is that as we
all know, thanks to Fama-French and others, there is not just one
market factor, which I identify with the market model. The market
model, it seems to me, is an old-fashioned way of looking at the
stock market that says there is one systematic factor and everything
else is diversifiable risk. Fine, there are several factors, but let’s
get beyond the statistical approach. Let’s get into the economics
and talk about what those factors really reflect and understand
them well enough so that we can look at different countries and
talk about how this country is managing at Central Bank versus
how that country is managing at Central Bank and how this
country is managing inflation versus how that country is managing
inflation.
Steve Buser:
Do you think there is a lot of work yet to be done before a naïve
individual like myself can just blindly invest in international
funds? I am going to go back to the original Treynor article that
says, “Well, it’s in the marketplace, those shares have to be held by
someone. So I will own a piece of it."
Jack Treynor:
Sounds like you’re investing in China.
Steve Buser:
Yes.
Jack Treynor:
I don’t understand China, and maybe you are investing in China
because you understand it a lot better than I do.
Steve Buser:
No. I’m investing in it because I –
Jack Treynor:
Just on principle.
Steve Buser:
Just on principle.
Jack Treynor:
It’s part of the global portfolio.
Steve Buser:
Part of the global portfolio. I am in there naïvely, and let’s say I’m
not even sure if I’m in China. I am in a Pacific fund that may not
be able to invest in China.
Jack Treynor:
But the whole _____.
Steve Buser:
But if there were a world market portfolio with China in it, I would
naïvely say that is my passive index. That is how I think about the
Treynor-Sharpe model for a naïve investor with no specialized
knowledge. It would put me in there.
I guess what I am hearing from you, and I think I heard the same
story from Sharpe, is whoa, not so fast. There is exchange rate
risk. There is political risk. There are additional risks that were
not in the basic model. So I guess I am just testing to see whether
you would advise caution in those areas pending further study.
The answer almost reminds me of your old Harvard Business
School lecture. Should Steve Buser invest in China blindly? They
would have said, “No, you shouldn’t do that. There is a required
rate of return that is very high for these unknown factors. We can’t
quantify them, but, Steve, it’s too pricy for you. If you don’t know
what you are doing, don’t buy that." Just like I should not buy an
individual U.S. stock. If I don’t know about a stock, don’t put that
stock in the market portfolio. Am I missing something or is it the
same message?
Jack Treynor:
Let me, a massively ignorant observer of China, lay his view on
you. The yuan is undervalued about 50 percent relative to Korea,
Thailand, Taiwan, Hong King, Singapore. Why? Why?
Steve Buser:
We know why and how. It’s massive manipulation, but –
Jack Treynor:
We know how. Let me throw out a really wild and crazy theory
about why. China looks at Europe and it sees that a euro currency
leads to a European community. China wants to make the yuan the
one strong currency in East Asia that won’t have any currency
crises and then build an East Asia community around that
currency.
Steve Buser:
You might very well be right and I was using that as an example
rather than specifics, but you have answered the question in both
the general and the specific there for me. Thank you.
Are there other categories of papers or themes in your writings?
I took a very broad brush and grouped things together. Are there
any other things we have missed that jump out and you say, “I’m
glad I did that” or “This is an important idea” that you would like
to add to the discussion at this point?
Jack Treynor:
Thank you. You mentioned macroeconomics, and I failed to
mention my interest in inflation. In a recent paper, I argue that in
industrial countries, unlike the models and arguments presented in
current textbooks, labor and capital are not substitutes.
I can see that in farming, and I can see it for fishermen and lakes.
You put more fishermen on a lake; you get more fish. Put more
hunters into a forest, and you will get more game out of that forest.
That’s substitution. That’s meaningful. But in industry, it seems
to me that workers and machines are complements. Two hands on
a steering wheel of a big truck is very productive. Four hands is
not more productive. And so it goes with machine tools.
It is not so obvious with something like a rolling mill or an oil
refinery, but it is still true. If it takes 137 people to run an oil
refinery, adding another 10 people probably will not increase
output; certainly nothing significant from adding another 137
people. I claim that is true for industry generally. Now, that has
two implications to me.
One is that when we try to understand inflation and we look at the
history of the business cycle for a company – countries and we
look at fluctuations and demand and prosperity and so on, these
two scarcities, scarcity of machines and scarcity of workers, are
going to be confounded, almost hopelessly.
My inflation argument, very quickly, for the machines being the
real cause goes like this. When workers and employers negotiate a
wage, they do not negotiate a real wage. They negotiate a money
wage, but they have a real wage in mind. The money wage they
negotiate is based on shared expectations about what is going to
happen to inflation. Now, suppose that the real wage turns out to
be different from what worker and employer expected. Why?
Because the marginal productivity of labor, according to Treynor,
is the labor productivity of the marginal machine. Any time the
identity of the marginal machine is changed –
Steve Buser:
Sounds like Karl Marx, by the way, but go ahead. (Laughter)
Jack Treynor:
Okay. (Laughter) He wouldn’t like Treynor very much.
Steve Buser:
He wouldn’t like your interpretations or mine, but sorry. Go
ahead.
Jack Treynor:
No, you’re right. So when productivity changes, intended or
unintended by policymakers, the productivity of those marginal
machines changes, the real wage changes. Now, holy smoke, the
people who negotiated the money wage are faced with the fact that
their assumption turned out to be wrong.
Okay, the money wage is now fixed. Something has to give. The
economy is determining a real wage. The money wage is fixed.
What could give? The price level and that is why machine scarcity
can drive inflation. It can increase inflation rate. It can slow it
down.
Now, my crazy paper says, “Look, this is what happened to Japan.
Japan was the first country to have a shrinking workforce. The
Central Bank looked at that and they said, ‘Oh, labor scarcity
drives inflation.’ They raised the overnight rate about 400 basis
points.”
Treynor with enormous benefit of hindsight says, “Guys, you
should have eased because your inflation is really driven by
machine scarcity. When you have a shrinking workforce and
workers are getting more scarce, machines are getting less scarce.
If you have got fewer workers, you are going to retire your oldest,
least efficient machines.”
Steve Buser:
Does the distinction between cost-push and demand-pull inflation
help in this context? I’m hearing more of a cost push story.
Jack Treynor:
Yes.
Steve Buser:
And if your policy tools are based on demand-pull inflation, then
obviously it’s going to aggravate the problem rather than resolve it.
Is that a fair assessment?
Jack Treynor:
I think it’s interesting to apply those terms, cost-push and demandpull, in this context. Now, as you know better than I, European
countries have fertility rates way below a replacement level, like
1.5 when it needs to be 2.1 or whatever; 2, anyway. They’re going
to repeat the Japanese experience and very soon.
Steve Buser:
So you’re not fond of my European investments or my China
investments. Okay. Are there other themes that you want to add
to the list at this point?
Jack Treynor:
Let’s see. I claim that I can use this goofy framework with the
machines and the marginal machines and so on to measure the cost
of a job.
If I can find a period of history for a country when the same
machines were marginal at the beginning of a period and the end
then all the investment during that period went to increasing the
number of jobs, then with appropriate price level adjustments, I
can add up the investments year by year.
I can compare the level of employment at the beginning with the
level at the end. The difference has to be the number of jobs
created by that accumulated investment.
Steve Buser:
So that is the key to your answer to one of your fed questions, or
that is the cost of the government creating a job. I didn’t get that
one. I had to give myself a zero on that particular question in your
paper with the quiz. But then again, I did not get to become fed
chairman either.
Jack Treynor:
Neither did I. (Laughter)
Steve Buser:
How did Mr. Bernanke do on your test?
Jack Treynor:
I would love to know.
Steve Buser:
Your papers demonstrate a clear understanding and respect for the
forces that lead many economists to conclude that investment
markets are likely to be efficient. Nevertheless, in at least one of
your papers you stated that as of that date you continued to believe
in active portfolio management. Are you still a believer in active
portfolio management?
Jack Treynor:
Yes. Although I am not a very active manager. In other words, I
think the cost of trading is high. One of the problems, of course, is
if you’re investing on value, you don’t get to trade unless you are
the inside bid or the inside ask, which would suggest that a double
auction market has a double winner’s curse.
Steve Buser:
Explain that for us if you would. What is this double winner’s
curse? First, what is the winner’s curse?
Jack Treynor:
As I understand the winner’s curse, it is the idea that in an auction
the guy who wins the auction may be the person with the worst
estimate of value. Hence an auction tends to make a winner out of
somebody who probably had a higher standard error of estimate of
value than some of the people who didn’t win the auction.
Steve Buser:
There is a similar argument by Miller, not Merton Miller but a
different Miller, that said that long positions in stocks are owned
by overly optimistic people, and that restrictions on short sales
make it difficult for people who are overly pessimistic to short in
equal numbers. Thus on average, there is an upward bias in prices.
You said there is a double winner’s curse. What is the other curse?
Jack Treynor:
Right. There is a winner’s curse for the bid and a winner’s curse
for the ask.
Steve Buser:
All right. So that, if you will, puts a buffer on your degree of
activeness because you have to execute, not just against the
observed price, but against the price at which you think you are
able to execute and that restricts your trading.
Jack Treynor:
I will probably regret saying this, but basically the bid and the ask
are tails of the same distribution. One is the highest estimate of the
distribution of value. The other is the lowest estimate of the
distribution of value. Of course, each is adjusted to provide an
expected reward.
Steve Buser:
Does that provide an opportunity for a dealer to make money?
You said that the disadvantage for a dealer is that you are
sometimes playing against people that really know what they’re
doing and are right. Is this a situation where you are sometimes
playing against people that think they know what they’re doing but
are wrong?
Jack Treynor:
Yes, I think there are times when a dealer can move faster than the
people who are submitting the bids and asks.
Steve Buser:
Going back to the theme of Treynor-Black side bets, in your own
opinion, are there important categories where you think that people
should deviate from the market portfolio either over long periods
of time or during short periods of time? Or should people be
sitting with the market portfolio?
Jack Treynor:
The real estate market is an obvious one to consider. I’m not
bullish about real estate in the U.S. market at this point. At the
very least it seems clear that something has been happening
nationally. It isn’t just a random coincidence of something
happening in local markets, and it ought to give us pause.
Steve Buser:
Interpreting that advice, you live in a gorgeous place in what I
assume is a very expensive part of a very expensive state. I
assume that you are over-weighted in your personal real estate
holdings. Do you consider those types of factors when then you
make your decisions on how much to invest in real estate out of
your marketable securities positions or do you ignore that type of
interaction?
Jack Treynor:
Oh, I think absolutely that should be a consideration. I have said
to many local people that if it were up to me, I’d be living in a
trailer.
Steve Buser:
I suspect that would get vetoed by other members of your family.
Jack Treynor:
(Laughter) You’re right.
Steve Buser:
One of the traditions we have in this series is to ask you to think
back and reflect on your career from the standpoint of a young
Jack Treynor just entering the profession today. We will start with
a young investor who’s just starting out how would you tell them
to approach the problem of managing their money?
Jack Treynor:
I would tell them to understand trading costs almost before they
ever bought or sold anything.
Steve Buser:
Does that suggest they should be first and foremost think of buy
and hold for the long term and avoid trading costs? Is that the
underlying message?
Jack Treynor:
I think that’s a pretty good message.
Steve Buser:
How about a young researcher just starting out and looking about
where could I possibly come up with the next capital asset pricing
blockbuster, or the next Treynor-Black blockbuster? Are there any
particularly promising avenues for them to focus on?
Jack Treynor:
Maybe this brings us at long last to the bean jar or to Francis
Galton, who was pointed out to me by Peter Bernstein. I had been
using the bean jar with my students, and I didn’t know that Francis
Galton had discovered that when he polled primitive farmers at a
country fair in England that the average of their guesses as to the
weight of a steer before it was actually weighed would come
within 1 percent of the true value.
Treynor says that should also work for markets except when there
is, for example, a very influential article in Barron’s or Forbes.
Then all the independent errors are replaced by one error, which is
probably a smaller error, but it doesn’t benefit from the
diversification effect across a lot of independent errors. This is a
principle for an active investor. If you think you can outsmart the
market price, can you document a systematic bias in the population
of investment opinion? Can you satisfy yourself that it is not just
millions of independent judgments about value that are reflected in
the price?
Steve Buser:
You have enjoyed a long and distinguished career on both sides of
the fence. If you were talking to a young practitioner who is just
starting out, is there any particular advice you would give the
young Jack Treynor?
Jack Treynor:
Well, suppose I was steering the young Jack Treynor to one of the
big money management firms of Boston or Los Angeles or
wherever. I might say this that I missed. If you have an insight
based on your training, your background, your special hobbies and
interests and so on, but you have an insight with market
implications, and you bet on them, you are basically saying, “That
is just the way I see things happening. I see these various other
things coming in combination with my insight to produce the
following investment result.” Now a hundred things can happen
that neither I nor you could anticipate that can invalidate that
insight.
Okay, so what does it cost you to be wrong in that situation? Very
little. If the market did not agree with you, if you’re satisfied that
the market did not see your insight, you looked at The Wall Street
Journal, and you looked at Barron’s. You looked at Forbes and
you looked at Business Week, and you could not see any hint of
your insight, then when you turn out to be wrong, all it is going to
cost you is your trading costs.
On the other hand, suppose you say, “Oh, I’m a little timid about
betting on my own insights. I have this enthusiasm, but I just don’t
have that much confidence. I’d feel a lot more comfortable if I
could see some reinforcement and some support.” Now you’re
talking about an insight that is probably in the consensus. If it
turns out to be wrong for any of the unforeseeable reasons, it is
going to be expensive.
Why do I bring this up? When the young Jack Treynor goes to
work for that big money management firm, and there is that big
boardroom table with the big boss sitting down there at the end,
and there is Jack Treynor sitting there about halfway down the
table and I say, “Boss, I’ve got an insight,” two things can happen.
The boss can poll people around the table, and they can say,
“Doesn’t ring our bell” or they can say, “Well, we don’t know.
We kind of thought about that but, maybe you got something there.
Maybe we ought to bet on that.” What is going to happen there?
Steve Buser:
With respect to career path, I have not heard of anyone that had the
same career path of bouncing from academics to practice and back
again. With the benefit of hindsight, would you do the same thing
again? Would you advise the young Jack Treynor to try a hybrid
career? Or would you say that you are better off if you go straight
into academics or straight into practice but really don’t try to blend
the two?
Jack Treynor:
Well, I think looking back that I was very lucky.
Steve Buser:
Lucky in the sense that it was worth the gamble or it was a bigger
gamble than you intended to make at the time?
Jack Treynor:
It was a bigger gamble than I thought.
Steve Buser:
From the academic view, I would have thought it was a
tremendous gamble beyond comprehension. But you just made
your own way, and didn’t fall off the cliff, fortunately, at least not
so any of the rest of us noticed.
Jack Treynor:
I think I was very lucky.
Steve Buser:
Well, that’s all the questions I have. Do you have any answers to
the questions I didn’t ask that you would like to add at this
particular point?
Jack Treynor:
I will say something and you can deal with it as you want to.
Steve Buser:
Very good.
Jack Treynor:
The problem with buy and hold, which you understand, is that
basically what the market does to you year by year multiplies over
time. If you lose 20 percent in Year 5, when you retire, you will be
20 percent poorer as a result of that 20 percent loss in Year 5.
And, of course, the same applies to Year 10, Year 20 and Year 40.
It is all multiplying, and I have tried to work out what this means
in terms of risk. I can express it in terms that you would not really
be grateful with, but the risk is huge.
After 40 years of investing or 30 years of investing or whatever,
that multiplying effect is just enormous. A few people are going to
be hugely rich. You are going to be reading about them in the
business pages of the newspapers, and so on. They are going to be
endowing universities and buying huge metropolitan newspapers
and doing things like that. Then there are going to be a huge
number of people who end up without very much money.
This is what is known to the statisticians as a right-skewed
distribution with a long point on the upper end and a big blunt,
heavy distribution with a lot of people on the lower end. I’ve
given some attention to this problem of multiplication.
As you well know, there is a limit to how much diversification you
can achieve by going across stocks or even across countries. But
basically each year’s investment surprise in the market is almost
uncorrelated with the investment surprise in other years, if we
ignore Treynor’s theory about bulls, bears and market bubbles.
Well, how can we use that? If we could convert that multiplication
into addition, if we could create an index fund or an Arnott-type
fund that basically varied with the market level as a logarithm of
the market level, then year-by-year changes in the value of our
investment would add instead of multiplying. We would have over
40 years of investing or 30 years. And we would have the
opportunity to diversify across those additive contributions from
the individual years.
Steve Buser:
What is the hang-up? Why can’t we do that today? Why can’t
someone create that?
Jack Treynor:
Oh, very good point. Yeah, somebody could do that today. If the
market doubles this year, next year you can sell off half your
stocks and then –
Steve Buser:
Or could a fund do that automatically for us? Not the old portfolio
insurance approach but something similar to that in automatic
trading.
Jack Treynor:
Yeah, exactly. Can’t we create an institution that could do that
trading, that after every bad year, buy more stocks? After every
good year, sell stocks and so on. Yeah. There are two problems.
One is trading costs and the other is taxes.
Steve Buser:
All right, because we did have things called constant dollar plans
and constant ratio plans where the Merrill Lynches of the world
did offer at least something resembling that.
Jack Treynor:
That kind of approached this kind of program.
Jack Treynor:
You asked if there were any afterthoughts. I don’t know how to
phrase this exactly, but it seems to me as I look back with my
interest in economics and investing that I see ideas being picked up
and used with more enthusiasm by the investment community than
by the academic community.
For example, Tobin’s Separation Theorem. I’ll bet you could find
a lot of well-trained economists who couldn’t even tell you what
the separation theorem is about. But I suspect that George
Ackerlof's paper on lemons is going to get a lot of use by investors
because, as you well understand, when investors buy stocks they
would dearly love to know if they are buying lemons. I see that
kind of pattern going on over time and over a long period of time.
I’d be interested in your thinking about that.
Steve Buser:
Well, I come from a biased view. I’ve taught investments for a
bunch of years, and those are precisely the issues we focused on.
Under the separation theorem, there is a portfolio out there that
investors should be holding along with a risk-free position. Then
with the Treynor-Black model, you should be supplementing the
separation theorem as certain opportunities come to you. We even
went beyond Treynor and Black. I don’t even know if you would
approve, but we also teach that if you have certain endowments
that are non-traded, your human capital, your house –
Jack Treynor:
Mm-hm. Okay. Yeah.
Steve Buser:
and those positions are not voluntary Treynor and Black side bets,
but they’re part of your portfolio, then how can you –
Jack Treynor:
Complement.
Steve Buser:
– complement. The first thing, of course, is to lay off the
systematic risk and pull that out of the house. Then you may find a
matching offsetting position, so there may be a Treynor-Black-type
side bet that becomes optimal only for someone who’s
overcommitted in some other area.
Same thing if you have an inherent short position. Someone facing
retirement and thinking about moving south, should they be
investing in Florida real estate? If there were a retirement REIT
that would be a package of things you could invest in to hedge
against.
Jack Treynor:
That’s an idea, yeah.
Steve Buser:
So, yes, I have been teaching it, but I maybe part of a very small
part of the academic community. I guess we are running out of
time here. We are down to one minute of tape. So you have one
more minute to throw something on the fire here.
Jack Treynor:
I hope the academics will take an interest in my crazy inflation
theories at some point.
Steve Buser:
All right. We will put that on the burner and ask some other
people about it. I’m not sure it's that all that crazy. Under the
heading of cost-push, they might very well have some sympathy
for the idea. Thank you.