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An equilibrium approach for tactical asset allocation: Assessing Black-

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Journal of Economics and International Finance Vol. 3(10), pp. 553-563, 22 September, 2011
Available online at http://www.academicjournals.org/JEIF
ISSN 2006-9812 ©2011 Academic Journals

Full Length Research Paper

An equilibrium approach for tactical asset allocation:

Assessing Black-Litterman model to Indian stock
market
Alok Kumar Mishra1*, Subramanyam Pisipati2 and Iti Vyas3
1
Department of Economics, University of Hyderabad, India.
2
Evalueserve.Com Pvt. Ltd., Gurgaon, India.
3
Indira Gandhi National Open University, New Delhi, India.
Accepted 4 August, 2011

In practice, mean-variance optimization results in non-intuitive and extreme portfolio allocations, which
are highly sensitive to variations in the inputs. Generally, efficient frontiers based on historical data
lead to highly concentrated portfolios. The Black-Litterman approach overcomes, or at least mitigates,
these problems to a large extent. The highlight of this approach is that it enables us to incorporate
investment views (which are subjective in nature) and assigns confidence levels to the views at the
modeler’s discretion. These aspects make the Black-Litterman model a strong quantitative tool that
provides an ideal framework for strategic/tactical asset allocation. The present study is an endeavor in
this direction. It considers the weak and strong aspects of both models and demonstrates how their
optimization procedures are put into practice in the context of Indian equity markets. To represent the
Indian equity markets, the study considered the Bombay stock exchange (BSE) published sectoral
indices for tactical asset allocation. In different trials, the performance of the two approaches is
compared empirically. The study found that the Black-Litterman efficient portfolios achieve a
significantly better return-to-risk performance than the mean-variance optimal approach/strategy.

Key words: Black-Litterman model, reverse optimization, tactical asset allocation, implied equilibrium return,
portfolio optimization, tracking error volatility.

INTRODUCTION

Recent years have witnessed a heightened interest in
portfolio management not only in the investors‟
community, but in the chief executive officer‟s (CEO‟s)
office as well. Despite its growing popularity, recent
benchmarking studies have identified portfolio
management as the weakest area in financial product
innovation management. Active portfolio management
leads to future investment management and institutional
*Corresponding author. E-mail: mishra78eco@yahoo.com.
Abbreviations: BSE, Bombay stock exchange; ER, expected
returns; CAPM, capital asset pricing model; CD, consumer
durable; CG, consumer good; FMCG, fast moving consumer
goods; HC, healthcare; IT, information technology; GICS, global
industry classification standard.
portfolio construction. The first novel approach of
optimizing the portfolio was suggested by Markowitz
(1952), who published an article on portfolio selection in
Journal of Finance 1952 (Black and Litterman, 1991).
There have been various extensions and developments
made in Markowitz model such as single index model,
capital asset pricing model (CAPM), Arbitrage pricing
theory etc. However, it is still widely used. Portfolio
models are decision-making tools intended to help
portfolio managers to decide optimal weights of the
assets within a fund or a portfolio. The novel academic
contribution of Markowitz portfolio has miserably failed in
the real financial market because of few inherent
assumptions. First, the traditional mean variance
approach requires a complete set of expected return and
risk to generate the optimal portfolio weights. Most
analysts and portfolio managers, however, do not have
return expectations for the entire asset class
554 J. Econ. Int. Finance
universe. Second, mean variance optimization frequently
leads to extreme and implausible portfolio weights in
either direction. These weights are excessively sensitive
to change in expected return.
These practical problems in using Markowitz‟s mean
variance model of portfolio optimization motivated Black
and Litterman (1992) to develop a new model in the early
1990s. Black-Litterman asset allocation model is a
sophisticated portfolio construction method that
overcomes the limitations of the Markowitz model such
as problem of unintuitive, highly concentrated portfolios,
input sensitivity, and estimation error maximization.
Black-Litterman model uses a technique known as
reverse optimization to determine the implied returns of a
portfolio based on the available market capitalization of
the asset classes being optimized. It also provides a
framework to combine the subjective views of an investor
regarding the expected return of one or more assets, with
the market equilibrium vector of expected returns (ER) to
form a new, mixed estimate of expected returns.
Tactical equity asset allocation policy across various
sectors is the biggest challenge faced by the Indian
equity fund managers. It has been observed that the
sector allocation of sample equity funds over a period
remains constant. This suggests that the Indian equity
fund managers are not focusing on tactical asset
allocation, which can be attributed to the fact that the
equity markets are less researched. However, with the
advent of globalization and entry of multinational asset
management companies in India, it has become essential
for the Indian equity fund managers to focus on tactical
asset allocation strategies. Our paper is an attempt to
examine the Black-Litterman approach in the context of
the Indian stock market. Further, the study of Black-
Litterman model has both academic and practical
motivations. Integrating quantitative portfolio models with
judgments of portfolio managers, as is done in the Black-
Litterman model, has been motivated by various
discussion on increasing the usefulness of quantitative
models for global portfolio management (Giacometti et al,
2005).
LITERATURE REVIEW
Here, a brief overview of the references to Black-
Litterman model in literature is outlined. Though the initial
paper Black and Litterman (1991) provided some insight
on the model, it did not include significant details,
including necessary data set to reproduce the results.
They introduced a parameter, weight on views, which is
used in a few other papers but not clearly defined. In their
second paper on the model, Black and Litterman (1992)
provided detailed discussion on the model along with the
major assumptions. The authors presented several
results and most of the input data required to generate
the results. However their assumptions were not
documented in an easy-to -use manner. As a result,
reproducing results are rather difficult.
Bevan and Winkelmann (1998) provided detail on how
they employed Black-Litterman as part of their broader
asset allocation process at Goldman Sachs, including
some calibrations of the model, which they perform. He
and Litterman (1999) presented a clear and reproducible
discussion on Black-Litterman. Satchell and Scowcroft
(2000) claimed to demystify Black-Litterman model, but
did not provide enough information to reproduce their
results. Moreover, they seemed to differ on the parameter
τ („Tao‟) with other authors. No intuitive reason was
specified as such in the study to back their assertion that
τ („Tao‟) should be set to 1. However, they did provide a
detailed derivation of the master formula of Black-
Litterman model.
Christadoulakis (2002) studied the details of Bayesian
mechanisms, assumptions of the model and enumerated
the key formulas for posterior returns. Herold (2003)
provided an alternative view of the problem by examining
optimizing alpha generation, essentially specifying that
the sample distribution has zero mean. He provided
some additional measures, which can be used to validate
that the views are reasonable. Krishnan and Manis
(2005) provided an extension to the Black-Litterman
model, adding another aspect which is uncorrelated with
the market. They called it the two-factor Black-Litterman
model and showed an example of extending Black-
Litterman model with a recession factor.
Mankert (2006) provided a rich literature on the Black-
Litterman model and also presented a detailed
transformation between the two specifications of Black-
Litterman master formula for the estimated asset returns.
She also provided a new approach on the value τ („Tao‟),
from the point of view of sampling theory. Meucci (2006)
provided a method to use non-normal views of Black-
Litteraman model. Barga and Natale (2007) described a
method for calibrating the uncertainty in the views using
tracking error volatility. This metric is well known for its
use in benchmark relative portfolio. Meucci (2005)
extended the method of non normal views in Black-
Litterman model to any model parameter, which allowed
both full distribution analysis and scenario analysis.
The aforementioned review vindicates the different
application of Black-Litterman approach in the context of
developed market. However, there is no similar study for
the Indian market. In the following chapters of this paper,
we attempt to empirically examine the Black-Litterman
approach in the context of the Indian equity market.
RESEARCH METHODOLOGY AND DATA DESCRIPTION
The Black-Litterman model
The Black and Litterman (1990, 1991, 1992) asset allocation model
is a sophisticated asset allocation and portfolio construction method
that overcomes the drawbacks of traditional mean-variance
optimization. The Black-Litterman model uses a Bayesian approach
to combine the subjective views of investors about the expected

return of assets. The practical implementation of the Black-
Litterman model was discussed in detail in the context of global
asset allocation (Bevan and Winkelmann, 1998), sector allocation
(Wolfgang, 2001) and portfolio optimization (He and Litterman,
1999). In order to incorporate the subjective views of investors, the
Black-Litterman model combines the CAPM (Sharpe, 1964),
reverse optimization (Sharpe, 1974), mixed estimation (Theil, 1971,
1978), the universal hedge ratio/Black‟s global CAPM (Black and
Litterman 1990, 1991, 1992; Litterman, 2003), and mean-variance
optimization (Markowitz, 1952). The Black-Litterman model creates
stable and intuitively appealing mean-variance efficient portfolios
based on investors‟ subjective views and also eliminates the input
sensitivity of the mean-variance optimization. The most important
input in mean-variance optimization is the vector of expected
returns. The model starts with the CAPM equilibrium market
portfolio returns starting point for estimation of asset returns, unlike
previous similar models started with the uninformative uniform prior
distributions. The CAPM equilibrium market portfolio returns are
more intuitively connected to market and reverse optimization of the
same will generate a stable distribution of return estimations. The
Black-Litterman model converts these CAPM equilibrium market
portfolio returns to implied return vector as a function of risk-free
return, market capitalization, and covariance with other assets.
Implied returns are also known as CAPM returns, market returns,
consensus returns, and reverse optimized returns. Equilibrium
returns are the set of returns that clear the market if all investors
have identical views.
The following is the Black-Litterman formula (Equation 1) along
with detailed description of each of its components. In this paper, K
represents the number of views and N represents the number of
assets in the model.
E[ R]  [() 1  P '  1 P]1[() 1   P '  1Q] (1)
where, E[R] is the new (posterior) combined return vector (N × 1
column vector); τ, a scalar; Σ, the covariance matrix of excess
returns (N × N matrix); P, a matrix that identifies the assets involved
in the views (K × N matrix or 1 × N row vector in the special case of
1 view); Ω, a diagonal covariance matrix of error terms from the
expressed views representing the uncertainty in each view (K × K
matrix); ∏, the implied equilibrium return vector (N × 1 column
vector); Q, the View Vector (K x 1 column vector).
The Black-Litterman model uses the equilibrium returns as a
starting point and the equilibrium returns of the assets are derived
using a reverse optimization method using Equation 2.
  wmkt (2)
where, , is the implied equilibrium excess return vector; , a risk
aversion coefficient; , the covariance matrix, and wmkt, the market
capitalization weight of the assets.
The risk aversion coefficient characterizes the expected risk-
return tradeoff and it acts as a scaling factor for the reverse
optimization. The risk aversion coefficient can be calculated using
equation 3.
RB  rf
 (3)
 B2
The implied equilibrium return vector is nothing but the market
capitalization-weighted portfolio. In the absence of views, investors
should hold the market portfolio. However, Black-Litterman model
allows investors to incorporate their subjective views on the
Mishra et al. 555
expected return of some of the assets in a portfolio, which may
differ from the implied equilibrium returns. The subjective views of
investors can be expressed in either absolute or relative terms.
where, Q, the view vector, which is k × 1 dimension; k, the number
of views, either absolute or relative. The uncertainty of views results
in a random, unknown, independently, normally distributes error
term vector () with mean 0 and covariance matrix . Thus a view
has the form Q+.
 Q1    1 
   
 :   : 
Q      (4)
: :
   
Q   
 k  k
Investor views on the market and their confidence level on the
views form the basis for arriving at new combined expected return
vector. With respect to investor views, we need to consider the
following aspects while developing the Black-Litterman model:
1. Each view should be unique and uncorrelated with the other.
2. While constructing the views, we need to ensure that the sum of
views is either 0 or 1, which ensures that all the views are fully
invested.
The investor view matrix (P) was constructed differently by various
authors. He and Litterman (1999) and Izorek (2005) used a market
capitalization weighted scheme, whereas Satchell and Scowcroft
(2000) used an equal weighted scheme. However, market
capitalization weighted scheme is applicable only in relative views.
The expected return on the views is organized as a column vector
(Q) expressed as Kx1 vector.
Omega, the covariance matrix of views, is a symmetric matrix
with non-diagonal elements as 0s. For calculating it, we have
assumed that the variance of the views will be proportional to the
variance of the asset returns, just as the variance of the prior
distribution is. This method has been used by He and Litterman
(1999) and Meucci (2006).
Using these ER, risk aversion coefficient (λ) and covariance
matrix (∑), new asset weights can be allocated using equation 5.
Weights (W BL) = (λ∑)-1*ER (5)
Before we attempt to detail the empirical examination of the Black-
Litterman model, it might be useful to give an intuitive description of
the major steps, which are presented in Figure 1.
Data
The current study is based on various sectoral indices constructed
and maintained by the Bombay Stock Exchange Limited (BSE),
India. BSE maintains eleven sectoral indices. We have discarded
power (utilities) and realty indices because BSE started maintaining
these indices in 2007 only, and therefore there is little historical
data. Moreover, including them in the study may create selection
bias. We have taken BSE 500 index as a benchmark for this study.
For these sectoral indices and for benchmark, we use monthly
closing prices from August 31st, 2004 to August 31st, 2009. The
data on sectoral indices and benchmark has been sourced from
Thomson Reuter‟s database.
The sectoral views on Indian equity market have been sourced
from HSBC monthly outlook bulletin. HSBC‟s India monthly strategy
bulletin presents views and strategies on various asset classes and
financial instruments. These include equities, fixed income,
commodities and currencies.
556 J. Econ. Int. Finance
Market weights/
strategic weights
Equilibrium/implied
expected returns
Revised expected returns
Revised portfolio weights
Figure 1. Major steps behind the Black-Litterman model.
EMPIRICAL FINDINGS OF THE STUDY
As India is an emerging economy that could withstand
the after-effects of global financial meltdown, several
foreign institutional investors are keen on parking their
investments in the country. Each of them has different
long-term and short-term views on different sectors of the
Indian equity market. This has motivated to empirically
examine the tactical asset allocation across different
sectors of Indian equity market through Black-Litterman
approach.
For our study, we have considered BSE sector indices
as the proxy for different sectors of Indian equity market.
Nine out of eleven BSE sector series indices have been
short-listed to examine the Black-Litterman model. We
have excluded BSE power index and BSE realty index as
they are relatively younger in comparison to other
sectoral indices. The study has considered the monthly
closing price of nine BSE sectoral indices from
September, 2004 to September, 2009, which is around
fifty-four observations. The monthly closing price of
sectoral indices has been taken to compute the
continuous compounded return of monthly sectoral
indices by taking the natural logarithmic of price
difference. This is represented as follows:
Rt = Ln (Pt) – Ln (Pt-1)
Subjective views about
expected returns
Degree of confidence
in subjective views
where, Rt is the return at time „t‟; Pt, price at time „t‟, and
Pt-1, price at time„t-1‟.
A risk-return profile of nine different sectoral indices
over a period of seven years, from September, 2004 to
January, 2010, is presented in the Table 1 and Figure 2.
Table 1 and Figure 2 indicate the risk-return profiles of
nine BSE sectoral indices. As illustrated in Figure 1,
consumer good provides the highest return (24.82%) with
the risk (42.14%) and metal provides lowest return
(7.29%) with the risk (51.67%) among all the nine
sectoral indices.
Traditional mean variance optimization often leads to
highly concentrated, undiversified asset allocations. For
better understanding we analyze an opportunity set that
includes nine asset classes: consumer durable (CD),
consumer good (CG), fast moving consumer goods
(FMCG), auto, bank, healthcare (HC), information
technology (IT), oil and gas and metal. When developing
an opportunity set, one should select non-overlapping
mutually exclusive asset classes that reflect the investors‟
investable universe. In this paper, we have presented two
types of graphs – efficient frontier graphs and efficient
frontier asset allocation area graphs. Efficient frontier
displays returns on the vertical axis and the risk (standard
deviation) of returns on the horizontal axis. Efficient
frontier is the locus of points, which represents the
different combination of risk and return on an efficient
 Mishra et al. 557

Table 1. Historical risk-return profile of different sectors (September, 2004

to January, 2010)

Sector Risk (%) Return (%)

Consumer durable (CD) 43.64 12.95
Consumer good (CG) 42.14 24.82
Fast moving consumer goods (FMCG) 24.54 18.76
Auto 32.77 15.89
Bank 40.56 16.72
Healthcare (HC) 27.96 7.48
Information technology (IT) 30.60 11.11
Oil and gas 34.34 18.61
Metal 51.67 7.29

30%

25% CG

20%
FMCG Oil
Return
Return ()

Bank
Auto
15%
CD
IT
10%

HC Metal

5%
20%
20 25%
25 30%
30 35%
35 40%
40 45%
45 50%
50 55%
55 60%
70
Risk ()
Risk
Figure 2. Scatter plot of risk-return profile of different sector (September, 2004 to January,
2010).

asset allocation, where an efficient asset allocation is one
that maximizes return per unit of risk. This is presented in
Figure 3.
Efficient frontier asset allocation area graphs
complement the efficient frontier graphs. They display the
asset allocations of the efficient frontier across the entire
risk spectrum. Efficient frontier area graphs display risk
on the horizontal axis. Figure 4, clearly summarizes that
there is a large asset allocation in the FMCG and CG.
The efficient frontier area graph displays all the asset
allocation on the efficient frontier. This is helpful to
visualize the efficient frontier graphs and the efficient
frontier asset allocation area graphs together because
one can simultaneously see the asset allocations
associated with the respective risk-return point on the
efficient frontier, and vice versa.
To avoid the limitation of efficient frontiers based on
historical data leads to highly concentrated portfolios in
the mean variance approach of Markowitz‟ s theory, the
Black-Litterman model (1992) proposed a better solution.
This was further researched and emphasized by Von
Neumann, Morgenstern and James Tobin. A rich
literature on this was well documented by Sharpe (1964,
1974), respectively. The pivotal point of Black-Litterman
model is implied returns. Implied returns (otherwise
known as equilibrium returns) are the set of sectoral
indices returns that clear the market if all investors have
identical views. This means the market follows the strong
form efficiency of the efficient market hypothesis or leads
to a perfect competitive market. To compute the
equilibrium returns of the sectoral indices, we need an
input parameter, that is, risk aversion coefficient. The risk
aversion coefficient characterizes the risk-return trade off.
Risk aversion coefficient is the ratio of risk-return and
558 J. Econ. Int. Finance

25%

24%

23%

22%
Return ()
Return 21%

20%

19%

18%

17%

16%

15%
6%
6 7%
7 8%
8 9%
9 10%
10 11%
11 12%
12 13%
13
Risk ()Risk

Figure 3. Efficient frontier. historical return versus risk.

Table 2. Variance-covariance matrix of sectoral index.

CD CG FMCG Auto Bank HC IT Oil Metal

CD 0.0156 0.0122 0.0039 0.0089 0.0113 0.0076 0.0070 0.0096 0.0148
CG 0.0122 0.0146 0.0040 0.0089 0.0113 0.0066 0.0051 0.0099 0.0152
FMCG 0.0039 0.0040 0.0049 0.0042 0.0034 0.0033 0.0026 0.0033 0.0054
Auto 0.0089 0.0089 0.0042 0.0088 0.0080 0.0056 0.0052 0.0074 0.0115
Bank 0.0113 0.0113 0.0034 0.0080 0.0135 0.0060 0.0051 0.0085 0.0130
HC 0.0076 0.0066 0.0033 0.0056 0.0060 0.0064 0.0046 0.0055 0.0092
IT 0.0070 0.0051 0.0026 0.0052 0.0051 0.0046 0.0077 0.0043 0.0080
Oil 0.0096 0.0099 0.0033 0.0074 0.0085 0.0055 0.0043 0.0097 0.0127
Metal 0.0148 0.0152 0.0054 0.0115 0.0130 0.0092 0.0080 0.0127 0.0219

variance of the benchmark portfolio. The mathematical
representation of risk aversion coefficient (denoted by λ)
is as follows:
RB  rf

 B2
where, RB is the return on benchmark; rf, the risk free
2
rate, and B , variance of the benchmark.
This paper considered BSE 500 as the benchmark
index to compute the risk aversion coefficient. BSE 500 is
a broad national index, which represents 93% of the total
market capitalization of BSE. Further, the nine sectoral
indices are the member constituents of the BSE 500
index. We have considered 91-day treasury bill rate as
the risk free rate. By computing the ratio of risk premium
and variance of BSE 500, we have calculated the
risk aversion coefficient (λ) at 4.2%. The risk aversion
coefficient characterizes the risk return trade off. From
the monthly return series of sectoral indices, we have
generated the variance-covariance matrix. This is
represented in Table 2.
To compute the weighted market capitalization of each
of the sectoral indices, we have considered the closing
prices and shares outstanding of each member
constituents on January 31, 2010, as this is the end date
of the study period. The market capitalization weights are
represented in the following Table 3.
In Table 3, the highest market capitalization weights
belong to oil and gas (23.89%) and the minimum weight
belongs to CD (0.55%). This is because both oil and gas
and CDs have maximum and minimum market
capitalization, respectively.
Finally, the implied excess returns of the sectoral
indices have been computed by considering their
corresponding risk aversion coefficient (λ) and market
 Mishra et al. 559

Table 3. Implied returns, market capitalization weights (W mkt)

Sector Market capitalization* Market capitalization weight (%)

Consumer durable (CD) $ 1,129,731 0.55
Consumer good (CG) $ 20,455,001 9.94%
FMCG $ 14,465,979 7.03%
Auto $ 13,126,272 6.38%
Bank $ 30,777,638 14.96%
Healthcare (HC) $ 10,530,561 5.12%
Information technology (IT) $ 28,267,161 13.74%
Oil and gas $ 49,153,328 23.89%
Metal $ 37,803,996 18.38%
st
*Dated 31 January, 2010.

Table 4. Implied return (П = λ ∑W mkt) of sectoral indices - risk profile (September, 2004 to
January, 2010).

Sector Risk (%) Total implied return* (%)

Consumer durable (CD) 43.64 5.55
Consumer good (CG) 42.14 5.56
FMCG 24.54 4.95
Auto 32.77 5.33
Bank 40.56 5.47
Healthcare (HC) 27.96 5.17
Information technology (IT) 30.60 5.12
Oil and gas 34.34 5.39
Metal 51.67 5.84
*Total implied return = implied excess return + risk free rate

capitalization weights (Wmkt). This is represented in
Table 4.
After generating the implied return and risk of the
sectoral indices, we have generated the optimized
portfolio efficient frontier. Here, it is understood that
implied returns are considered as the ER of the
respective sectoral indices. This is same as Markowitz
mean variance approach of portfolio optimization. This is
represented in the Figures 4a, 4b, 5 and 6.
Comparing the historical return based efficient frontier
allocation with implied return based efficient frontier
allocation, it can be clearly summarized that historical
returns lead to concentrated portfolios and implied
returns lead to diversified portfolios. The point on the
efficient frontier with the highest Sharpe ratio in Figure 4
is the presumed efficient benchmark. These implied
returns are the starting point for the Black-Litterman
model. However, it has been observed that most
investors stop thinking beyond this point while selecting
the optimal portfolio. If investors or market participants do
not agree with implied returns, the Black-Litterman model
provides an effective framework for combining the implied
returns with the investor‟s unique views or perception
regarding the markets, which result in well diversified
portfolios reflecting their views.
To implement the Black-Litterman approach, an asset
manager has to express his or her views in terms of
probability distribution. Black-Litterman assumes that the
investor has two kind of views –absolute and relative. For
now, we assume that the investor has „k‟ different views
on linear combinations of ER of the „n‟ assets. This is
explained in details as an equation (Equation 1) in the
methodology section. Hence, we are not explaining this
further here.
In this paper, we have considered the combination of
one absolute and two relative views on the BSE sectoral
indices such as metal, CD, CG, FMCG and autos. These
views are expressed as follows:
Absolute view
View 1
Metals will generate an absolute return of 6%.
560 J. Econ. Int. Finance

100%

90%

80%

% Allocation per Sector

70%

60%

50%

40%

30%

20%

10%

0%
Risk (Standard Deviation)

CD CG FMCG Auto Bank HC IT Oil Metal

Figure 4a. Mean variance frontier allocations (historical).

8%

7%
()
Return

6%
Return

IR Optimal Portf olio

5%

4%
6%
6 7 7% 88% 9%
9 10%
10 Risk
11%
11 12%
12 13%
13 14%
14 15%
15
Risk ()

Figure 4b. Efficient frontier: implied return versus risk.

100%

80%
% Allocation per Sector

60%

40%

20%

0%
6
6% 7
7% 7
7% 8
8% 9
9% 10
10% 11
11% 12
12% 13
13% 14
14%
Risk (Standard deviation)
Risk (Standard Deviation)
CD CG FMCG Auto Bank HC IT Oil Metal
Figure 5. Mean variance allocations (Implied returns).

29.27%
16.83%
CD CG FMCG
Figure 6. Sectoral allocation pie chart.
Relative views
Views 1
CG outperform CDs by 2%.
Views 2
Auto sector will outperform FMCG by 1%.
Combining views with the equilibrium expected
returns
The Black-Litterman optimal portfolio is a weighted
combination of the market portfolio and the views of the
investor. The views are combined with the equilibrium,
and positions are taken in relation to the benchmark
portfolio on assets to which investors have expressed
views. The size of the gamble taken depends on three
different variables: the views, the level of confidence
assigned to each view, and the weight-on-views. It
depends on the views specified by the investor. The more
confidence the investor assigns on a view, the bigger the
bets are on that asset. The matrix  in Equation 1
represents the levels of confidence on the views. There
is, however, one more variable that affects the size of the
bets taken in relation to the equilibrium portfolio.
Mishra et al. 561
0.68%
12.19%
0.00%
8.60%
7.83%
18.34%
6.26%
Auto Bank HC IT Oil Metal
By using the aforementioned formula and views, we
have computed the total implied returns (Black-Litterman
return) for all sectoral indices presented in Table 5. It
shows that CG and CD provide the maximum and
minimum returns, respectively, while metal and FMCG
provide the maximum and minimum risk with lower return
of 6.07% and 4.02%, respectively.
By employing the Black-Litterman return and risk, we
have constructed the efficient frontier and efficient frontier
area graph in Figures 7 and 8, respectively. In Figure 8, it
can be clearly summarized that the asset allocation
concentration is more in case of CG and FMCG sector.
However, in comparison to Markowitz mean variance
classical approach, the Black-Litterman model produces
a more diversified portfolio.
Figure 9 plots the efficient frontier generated by implied
return and Black Litterman return. It can be concluded
that Black-Litterman model provides the optimal portfolio
with maximum return and minimum risk in comparison to
implied return based and mean variance based portfolio
optimization.
MAJOR FINDINGS
In this article, we have demonstrated the intuition behind
the portfolio optimization model presented by Black and
Litterman (1992). Their approach helps overcome the
limitations of the Markowitz (1952) approach. We have
applied the Black-Litterman approach for the Indian BSE
562 J. Econ. Int. Finance

Table 5. Implied return-risk profile of different sector (September, 2004 to January, 2010).

Sector Risk (%) Total Implied Return* (%)

Consumer durable (CD) 43.64 3.60
Consumer good (CG) 42.14 7.50
FMCG 24.54 4.02
Auto 32.77 5.96
Bank 40.56 5.97
Healthcare (HC) 27.96 4.33
Information technology (IT) 30.60 3.94
Oil and gas 34.34 5.93
Metal 51.67 6.07
*Total implied return = implied excess return + risk free rate

8.0%
BL Optimal Portfolio

7.0%
Return ()
Return

6.0%

5.0%

4.0%
6%
6 7%
7 8%
8 9%
9 10%
10 11%
11 12%
12 13%
13 14%
14 15%
15
Risk ()
Risk

Figure 7. Efficient Frontier: Black-Litterman return versus risk.

100%

80%
% Allocation per Sector

60%

40%

20%

0%
6%
6 7%
7 7%
7 7%
7 8%
8 8%
8 9%
9 10%
10 11%
11 12%
12
Risk(Standard
Risk (Standard Deviation)
deviation)
CD CG FMCG Auto Bank HC IT Oil Metal
Figure 8. Mean variance allocations (Black-Litterman).
 Mishra et al. 563

8.0%

7.0% BL Optimal Portf olio

Return ()
Return 6.0%

5.0%
IR Optimal Portf olio

4.0%
6.0%
6 .0 7.0%
7.0 8.0%
8.0 9.0%
9.0 10.0%
10 .0 11.0%
11.0 12.0%
12.0 13.0%
13.0 14.0%
14.0 15.0%
15.0
Risk ()
Risk

BL Efficient frontier Implied Efficient Frontier

Figure 9. Efficient Frontier: Black-Litterman versus implied return.

sectoral indices such as CD, CG, FMCG, auto, bank, HC,
IT, oil and gas and metal from September, 2004 to
September, 2009. The major finding of the study is that
the Black-Litterman model produces the best optimal
portfolio with the maximum return and minimum risk in
comparison to the classical mean variance and implied
return based approach. The major limitations of the study
are that the sectoral indices published by BSE are not as
per the global industry classification standard (GICS)
followed internationally and that the number of the stocks
in CD index is not enough to represent the sector
broadly. The alternative approach to this can be
constructing customized indices as per the GICS sectoral
classification and applying the Black-Litterman approach
for an in-depth analysis and portfolio diversification.
However, this is beyond the scope of the current study. It
is also important to note here that this paper is still
presented the results in the mean variance optimization
framework, which cannot deal with higher moments. With
more in-depth analysis such as portfolio selection with
higher moments, Black-Litterman model will develop into
a powerful tool for portfolio optimization and
diversification for investors. We hope this paper provokes
more research in this direction in future.
ACKNOWLEDGEMENT
The authors thank an anonymous referee for very useful
and constructive comments on the previous draft of the
paper.
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