In this article, Youssef LOURAOUI (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022) presents the Black-Litterman model, used to determine optimal asset allocation in a portfolio. The Black-Litterman model takes the Markowitz model one step further: it incorporates an investor’s own views in determining asset allocations.
This article is structured as follows: we introduce the Black-Litterman model. We then present the mathematical foundations of the model to understand how the method is derived. We finish with an example to illustrate how we can implement a Black-Litterman asset allocation in practice.
Introduction
The Black-Litterman asset allocation model, developed by Fischer Black and Robert Litterman in the early 1990’s, is a complex method for dealing with unintuitive, highly concentrated, input-sensitive portfolios produced by the Markowitz model. The most likely reason why more portfolio managers do not employ the Markowitz paradigm, in which return is maximized for a given level of risk, is input sensitivity, which is a well-documented problem with mean-variance optimization.
The Black-Litterman model employs a Bayesian technique to integrate an investor’s subjective views on expected returns for one or more assets with the market equilibrium expected returns (prior distribution) of expected returns to get a new, mixed estimate of expected returns. The new vector of expected returns (the posterior distribution) is a complex, weighted average of the investor’s views and the market equilibrium.
The purpose of the Black-Litterman model is to develop stable, mean-variance efficient portfolios based on an investor’s unique insights that overcome the problem of input sensitivity. According to Lee (2000), the Black-Litterman Model “essentially mitigates” the problem of estimating error maximization (Michaud, 1989) by dispersing errors throughout the vector of expected returns.
The vector of expected returns is the most crucial input in mean-variance optimization; yet, Best and Grauer (1991) demonstrate that this input can be very sensitive in the final result. Black and Litterman (1992) and He and Litterman (1999) investigate various potential projections of expected returns in their search for a fair starting point: historical returns, equal “mean” returns for all assets, and risk-adjusted equal mean returns. They demonstrate that these alternate forecasts result in extreme portfolios, which have significant long and short positions concentrated in a small number of assets.
Mathematical foundation of Black-Litterman model
It is important to introduce the Black-Litterman formula and provide a brief description of each of its elements. In the formula below, the integer k is used to represent the number of views and the integer n to express the number of assets in the investment set (NB: the superscript ’ indicates the transpose and -1 indicates the inverse).
Where:
- E[R] = New (posterior) vector of combined expected return (n x 1 column vector)
- τ = Scalar
- Σ = Covariance matrix of returns (n x n matrix)
- P = Identifies the assets involved in the views (k x n matrix or 1 x n row vector in the special case of 1 view)
- Ω = Diagonal covariance matrix of error terms in expressed views representing the level of confidence in each view (k x k matrix)
- П = Vector of implied equilibrium expected returns (n x 1 column vector)
- Q = Vector of views (k x 1 column vector)
Traditionally, personal views are used for prior distribution. Then observed data is used to generate a posterior distribution. The Black-Litterman Model assumes implied returns as the prior distribution and personal views alter it. The basic procedure to find the Black-Litterman model is: 1) Find implied returns 2) Formulate investor views 3) Determine what the expected returns are 4) Find the asset allocation for the optimal portfolio.
Black-Litterman asset allocation in practice
An investment manager’s views for the expected return of some of the assets in a portfolio are frequently different from the the Implied Equilibrium Return Vector (Π), which represents the market-neutral starting point for the Black-Litterman model. representing the uncertainty in each view. Such views can be represented in absolute or relative terms using the Black-Litterman Model. Below are three examples of views stated in the Black and Litterman model (1990).
- View 1: Merck (MRK) will generate an absolute return of 10% (Confidence of View = 50%).
- View 2: Johnson & Johnson (JNJ) will outperform Procter & Gamble (PG) by 3% (Confidence of View = 65%).
- View 3: GE (GE) will beat GM (gm), Wal-Mart (WMT), and Exxon (XOM) by 1.5 percent (Confidence of View = 30%).
An absolute view is exemplified by View 1. It instructs the Black-Litterman model to set Merck’s return at 10%.
Views 2 and 3 are relative views. Relative views are more accurate representations of how investment managers feel about certain assets. According to View 2, Johnson & Johnson’s return will be on average 3 percentage points higher than Procter & Gamble’s. To determine if this will have a good or negative impact on Johnson & Johnson in comparison to Procter & Gamble, their respective Implied Equilibrium returns must be evaluated. In general (and in the absence of constraints and other views), the model will tilt the portfolio towards the outperforming asset if the view exceeds the difference between the two Implied Equilibrium returns, as shown in View 2.
View 3 shows that the number of outperforming assets does not have to equal the number of failing assets, and that the labels “outperforming” and “underperforming” are relative terms. Views that include several assets with a variety of Implied Equilibrium returns are less intuitive, generalizing more challenges. In the absence of constraints and other views, the view’s assets are divided into two mini-portfolios: a long and a short portfolio. The relative weighting of each nominally outperforming asset is proportional to that asset’s market capitalization divided by the sum of the market capitalization of the other nominally outperforming assets of that particular view. Similarly, the relative weighting of each nominally underperforming asset is proportional to that asset’s market capitalization divided by the sum of the market capitalizations of the other nominally underperforming assets. The difference between the net long and net short positions is zero. The real outperforming asset(s) from the expressed view may not be the mini-portfolio that receives the good view. In general, the model will overweight the “outperforming” assets if the view is greater than the weighted average Implied Equilibrium return differential.
Why should I be interested in this post?
Modern Portfolio Theory (MPT) is at the heart of modern finance and its core foundations are structuring the modern investing panorama. MPT has established itself as the foundation for modern financial theory and practice. MPT’s premise is that beating the market is difficult, and those that do it by diversifying their portfolios appropriately and accepting higher-than-average investment risks.
MPT has been around for almost sixty years, and its popularity is unlikely to wane anytime soon. Its theoretical contributions have laid the groundwork for more theoretical research in the field of portfolio theory. Markowitz’s portfolio theory, however, is vulnerable to and dependent on continuing ‘probabilistic’ development and expansion. This article shed light on an enhancement of the initial Markowitz work by going a step further: to incorporate the views of the investors in the asset allocation process.
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Useful resources
Academic research
Best, M.J., and Grauer, R.R. 1991. On the Sensitivity of Mean-Variance-Efficient Portfolios to Changes in Asset Means: Some Analytical and Computational Results.The Review of Financial Studies, 315-342.
Black, F. and Litterman, R. 1990. Asset Allocation: Combining Investors Views with Market Equilibrium. Goldman Sachs Fixed Income Research working paper
Black, F. and Litterman, R. 1991. Global Asset Allocation with Equities, Bonds, and Currencies. Goldman Sachs Fixed Income Research working paper
Black, F. and Litterman, R. 1992. Global Portfolio Optimization.Financial Analysts Journal, 28-43.
He, G. and Litterman, R. 1999. The Intuition Behind Black-Litterman Model Portfolios. Goldman Sachs Investment Management Research, working paper.
Idzorek, T.M. 2002. A step-by-step guide to Black-Litterman model. Incorporating user-specified confidence levels. Working Paper, 2-11.
Lee, W., 2000, Advanced theory and methodology of tactical asset allocation. Fabozzi and Associates Publications.
Markowitz, H., 1952. Portfolio Selection. The Journal of Finance, 7(1): 77-91.
Michaud, R.O. 1989. The Markowitz Optimization Enigma: Is Optimized Optimal?. Financial Analysts Journal, 31-42.
Mossin, J. 1966. Equilibrium in a Capital Asset Market. Econometrica, 34(4): 768-783.
Sharpe, W.F. 1963. A Simplified Model for Portfolio Analysis. Management Science, 9(2): 277-293.
Sharpe, W.F. 1964. Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. The Journal of Finance, 19(3): 425-442.
About the author
The article was written in November 2021 by Youssef LOURAOUI > (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022).