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Multi-asset portfolio optimization and out-

of-sample performance: an evaluation of
Black–Litterman, mean-variance, and naïve
diversification approaches
a b a
Wolfgang Bessler , Heiko Opfer & Dominik Wolff
a
Center for Finance and Banking, Justus-Liebig-University Giessen,
Giessen, Germany
b
Deka Investment GmbH, Frankfurt, Germany
Published online: 08 Dec 2014.
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To cite this article: Wolfgang Bessler, Heiko Opfer & Dominik Wolff (2014): Multi-asset portfolio optimization
and out-of-sample performance: an evaluation of Black–Litterman, mean-variance, and naïve diversification
approaches, The European Journal of Finance, DOI: 10.1080/1351847X.2014.953699
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The European Journal of Finance, 2014
http://dx.doi.org/10.1080/1351847X.2014.953699
Multi-asset portfolio optimization and out-of-sample performance: an evaluation

of Black–Litterman, mean-variance, and naïve diversification approaches
Wolfgang Besslera∗ , Heiko Opferb and Dominik Wolffa

a Center
for Finance and Banking, Justus-Liebig-University Giessen, Giessen, Germany; b Deka Investment GmbH,
Frankfurt, Germany
(Received 16 November 2012; final version received 7 August 2014)
The Black–Litterman model aims to enhance asset allocation decisions by overcoming the problems of
mean-variance portfolio optimization. We propose a sample-based version of the Black–Litterman model
Downloaded by [FU Berlin] at 01:39 15 May 2015
and implement it on a multi-asset portfolio consisting of global stocks, bonds, and commodity indices,
covering the period from January 1993 to December 2011. We test its out-of-sample performance relative
to other asset allocation models and find that Black–Litterman optimized portfolios significantly outper-
form naïve-diversified portfolios (1/N rule and strategic weights), and consistently perform better than
mean-variance, Bayes–Stein, and minimum-variance strategies in terms of out-of-sample Sharpe ratios,
even after controlling for different levels of risk aversion, investment constraints, and transaction costs.
The BL model generates portfolios with lower risk, less extreme asset allocations, and higher diversifica-
tion across asset classes. Sensitivity analyses indicate that these advantages are due to more stable mixed
return estimates that incorporate the reliability of return predictions, smaller estimation errors, and lower
turnover.
Keywords: portfolio optimization; Black–Litterman; mean-variance; minimum-variance; Bayes–Stein;

naïve diversification; 1/N; Markowitz
JEL Classification: C61; G11
1. Introduction
The traditional mean-variance (MV) portfolio optimization (Markowitz 1952) has played a
prominent role in modern investment theory and has been widely discussed and tested in the
literature. In theory, it provides the investor with the optimal asset allocation if the portfolio
variance and return are the only relevant parameters and future asset returns and the covariance
matrix are given. However, when applied in an asset management setting, estimation errors in
input parameters (Jobson and Korkie 1981a; Michaud 1989), corner solutions (Broadie 1993),
and high transaction costs, resulting from extreme portfolio reallocations (Best and Grauer 1991),
often result in a poor out-of-sample portfolio performance.
Asset managers frequently try to cope with these shortcomings by implementing constraints
on the portfolio weights and turnover. In the literature, several variations and extensions of MV
are discussed that attempt to overcome its limitations. These suggestions range from imposing
portfolio constraints (Frost and Savarino 1988; Jagannathan and Ma 2003; Behr, Guettler, and
Miebs 2013) to the use of factor models (Chan, Karceski, and Lakonishok 1999), and Bayesian
methods for estimating the MV input parameters (Jorion 1985, 1986; Pastor 2000; Pastor and
∗ Corresponding author. Email: wolfgang.bessler@wirtschaft.uni-giessen.de

© 2014 Taylor & Francis
2 W. Bessler et al.
Stambaugh 2000). In a recent study, DeMiguel, Garlappi, and Uppal (2009) analyze whether
MV strategies and various extensions suggested in the literature are able to outperform a naïve-
diversified 1/N portfolio across a range of different stock data sets. They report that none of
the different MV strategies consistently outperforms a naïve equally weighted portfolio (1/N) in
an out-of-sample setting. However, Kirby and Ostdiek (2012) question these results, suggesting
that the results are mainly due to their research design and their data sets. They show that by
focusing on the tangential portfolio, DeMiguel, Garlappi, and Uppal (2009) place the MV model
at an inherent disadvantage in terms of turnover and estimation risk. Nevertheless, Kirby and
Ostdiek (2012) also find that the MV approach hardly outperforms the 1/N strategy at statistically
significant levels when transaction costs are included.
In contrast to the professional asset management industry, the academic literature has paid lit-
tle attention to the performance of the Black and Litterman (1992) model, which was derived
as an alternative approach to portfolio optimization more than 20 years ago. Since then the
Black–Litterman (BL) model has experienced an increasing attention among quantitative port-
folio managers (Satchell and Scowcroft 2000; Jones, Lim, and Zangari 2007). In the literature,
only a few authors analyze the rationale of the BL model, provide examples for applying the
methodology, or propose extensions of the model (Lee 2000; Satchell and Scowcroft 2000; Dro-
betz 2001; Herold 2005; Idzorek 2005; Meucci 2006; Chiarawongse et al. 2012; Bessler and
Wolff 2013). So far, there exists only little empirical evidence for the out-of-sample performance
of the BL model.
Our study contributes to the literature by empirically testing the BL model performance out-
of-sample. The main objectives are first to analyze whether the BL model is able to alleviate
the typical shortcomings of MV optimization, and second to evaluate its performance relative
to alternative asset allocation strategies in an out-of-sample setting with realistic investment
constraints. We propose a sample-based approach of the BL model that allows us to compute
its out-of-sample performance based on historic data sets. For the period from January 1993 to
December 2011, we compute the out-of-sample performance of BL, MV, and Bayes–Stein (BS),
as one of the most prominent extensions of MV, minimum variance (MinVar), as well as for two
naïve diversification approaches and evaluate the performance of each strategy. Furthermore, we
propose variations of the BL model by incorporating different reference portfolios and finally
analyze expansionary and recessionary sub-periods separately.
Relative to other studies on asset allocation strategies such as DeMiguel, Garlappi, and Uppal
(2009), Kirby and Ostdiek (2012), Behr, Guettler, and Miebs (2013), Murtazashvili and Voz-
lyublennaia (2013), our study extends the literature with respect to the following three aspects.
First, and most importantly, we include the BL model in the analysis. Second, we analyze all opti-
mization strategies for three different investor types with maximum desired portfolio volatilities
of 5%, 10% and 15%, while earlier studies usually focus only on the tangential portfolio. Third,
we implement portfolio optimization strategies based on multi-asset portfolios. Earlier studies
cited above focus solely on stock portfolios. Our empirical analysis covers the asset classes
developed and emerging stocks, government and corporate bonds, as well as commodities. In
particular, we expect that the additional asset classes, government bonds and commodities, offer
high diversification potentials, due to their historically low correlations with stocks. Given that
government bonds usually gain in value during stock market downturns, asset allocation models
that shift wealth from stocks to bonds during these periods should benefit relative to naïve strate-
gies such as the 1/N approach. Therefore, it is important to analyze how different asset allocation
strategies performed in a multi-asset context over the last two decades.
The European Journal of Finance 3
Our empirical results offer new insights into several dimensions. We find that for a multi-asset
universe all portfolio optimization strategies outperform relative to naïve equally weighted (1/N)
or strategically weighted portfolios. Yet the outperformance is insignificant for most MV and BS
portfolios, which is consistent with the results of Kirby and Ostdiek (2012) and DeMiguel, Gar-
lappi, and Uppal (2009). However, the BL portfolios exhibit significantly higher Sharpe ratios
than naïve strategies and consistently outperform MV. Additionally, BL portfolios have lower
portfolio turnover and offer more diversification across asset classes relative to MV portfolios.
Our sub-period analysis suggests that the BL model outperforms MV and naïve-diversified port-
folios particularly in recessionary periods. Sensitivity analyses indicate that the superiority of the
BL model results from more stable mixed return estimates that include the reliability of return
estimates (‘views’) and lead to a lower portfolio turnover. A variety of sensitivity analyses indi-
cates that our results are robust to different estimation windows, optimization constraints, and
to restrictions of the optimized portfolio weights. Our results also hold for different levels of
transaction costs and when transaction costs are included in the optimization function as well as
for larger and different sets of asset universes.
The remainder of this study is organized as follows. In Section 2, we discuss the asset alloca-
tion models employed, the related literature as well as the employed performance measures. We
provide the data and some descriptive statistics in Section 3 and present and discuss our empiri-
cal results in Section 4. Section 5 includes a description and discussion of the robustness checks.
Section 6 concludes.
2. Methodology
We analyze the out-of-sample performance of different optimization techniques and naïve diver-
sification rules. The optimization models employed include three alternative implementations
of the Black–Litterman (BL) model, the mean-variance (MV) and minimum-variance (MinVar)
portfolios, as well as the Bayes–Stein (BS) approach as one of the most prominent extensions of
MV. The naïve diversification rules analyzed are equally weighted portfolios (1/N) and strate-
gically weighted portfolios (st.w.). Table 1 summarizes all asset allocation models used in this
study. For the period from January 1993 to December 2011, we calculate monthly optimized
portfolios at the first trading day of each month, based on the different optimization approaches.
In line with DeMiguel, Garlappi, and Uppal (2009) and Daskalaki and Skiadopoulos (2011),
we employ a rolling sample approach. This means that at any point in time t (month), we
use data available up to and including time t (k observations) to compute optimized portfolio
weights. These weights are then used to compute the out-of-sample realized portfolio return over
the period [t, t + 1]. We repeat this process by moving the sample period one month forward
and computing the optimized weights for the next month. Rolling estimation windows offer the
advantage of being more responsive to structural breaks than expanding estimation windows. To
ensure the robustness of our results, we analyze different estimation window lengths. All opti-
mization models include realistic investment constraints. First, we include a budget restriction
according to Equation (1) which ensures that portfolio weights sum to one:

N
ωi = 1, (1)
i=1
where ωi is the portfolio weight of asset i and N is the number of assets in the portfolio. Second,
we exclude short selling since many institutional investors are restricted to long positions only
4 W. Bessler et al.
Table 1. Overview of asset allocation models included.
Number Model Abbreviation
Naïve asset allocation rules

1 1/N with rebalancing (benchmark strategy) 1/N
2 Naïve diversification (benchmark weights) with rebalancing st.w.
Portfolio optimization models
3 Sample-based mean-variance MV
4 Bayes–Stein BS
5 Minimum-variance MinVar
6 Black–Litterman with strategic weights as reference portfolio BL-st.w.
7 Black–Litterman with 1/N as reference portfolio BL-1/N
8 Black–Litterman with minimum variance as reference portfolio BL-MinVar
Notes: This table lists the various asset allocation models that we include in this study. The last column
of the table gives the abbreviation used to refer to the strategy in the tables in which the performance of
the various strategies is compared.
(Equation (2)):
ωi ≥ 0, with i = 1, . . . , N. (2)
Third, we limit the maximum portfolio volatility in order to distinguish between different
investor types in terms of their maximum desired portfolio risk (Equation (3)):

ω ω ≤ σ̂P , (3)
where ω is the vector of portfolio weights, is the covariance matrix of the asset returns, and
σ̂P is a predefined portfolio volatility constraint. The volatility constraint represents an upper
volatility bound, rather than a target volatility for the optimized portfolio. Such a volatility bound
provides the advantage that the asset allocation model may shift large fractions of wealth to low-
risk government bonds during stock market downturns, thereby preventing losses, whereas for
a specific target volatility (e.g. 10% p.a.) substantial fractions of wealth have to be invested in
stocks even if stock return estimates are negative. In the remainder of this section, we briefly
describe the methodology of the various asset allocation strategies implemented in this study.
2.1 Naïve diversification rules

We compute two naïve-diversified portfolios that serve as benchmark portfolios for the optimiza-
tion models. First, we calculate a 1/N strategy that invests equally in the N included assets. This
naïve diversified 1/N portfolio is a popular investment strategy for private investors (Benartzi
and Thaler 2001). In a recent study, Plyakha, Uppal, and Vilkov (2012) report that equal-
weighted (1/N) stock portfolios with monthly rebalancing achieve higher total mean returns,
four factor alphas (Fama and French 1993; Carhart 1997), and Sharpe ratios compared to both
value-weighted and price-weighted portfolios.1
As a second naïve diversification strategy, we compute strategically weighted portfolios (st.w.)
in which each asset obtains a strategic weight that is constant over time. We account for three
different investor clienteles – a ‘conservative’, a ‘moderate’, and an ‘aggressive’ one – and set
different strategic weights for bonds, commodities, and stocks depending on the investor type. To
Table 2. Strategically weighted portfolios.
Benchmark portfolio weights Optimization

Historic volatility constraint: max.
Bonds Stocks Commodities of benchmark portfolio volatility
Investor type (%) (%) (%) portfolio (% p.a.) (% p.a.)
Conservative 80 15 5 4.58 5.00

Moderate 45 40 15 6.66 10.00
Aggressive 10 65 25 9.72 15.00
Notes: This table provides the strategic weights for the three analyzed investor types: conservative, moderate, and aggres-
sive, which are used to compute naïve-diversified portfolios and implied return estimates. Within the asset class stocks,
emerging market stocks obtain a strategic weight of 25%, while developed market stocks obtain a strategic weight of
75%. Accordingly, in the asset class bonds, high-yield corporate bonds have a strategic weight of 25% and government
bonds 75%. We assume that the three investor types prefer a maximum expected portfolio volatility of 5%, 10% and
15%, respectively, which is compatible with the historic volatilities of the benchmark portfolios.
determine strategic weights we rely on the results of earlier studies and on discussions with prac-
titioners. Analyzing multi-asset portfolios including US stocks, bonds, and commodities for the
period from 1974 to 1997, Anson (1999) suggests that a moderate investor should allocate about
15% to commodities. Usually the risk of commodities is similar to equities (Bodie and Rosansky
1980; Gorton and Rouwenhorst 2006) and substantially larger than for bonds. Therefore, we set
the strategic allocation to commodities and stocks lower for conservative investors and higher
for aggressive investors. For the conservative, moderate, and aggressive investor clienteles, the
strategic weights for commodities are 5%, 15%, and 25% and for stocks 15%, 40%, and 65%,
respectively. Accordingly, the strategic weights for bonds are 80% for the conservative investor,
which might be, for instance, reasonable for pension funds, 45% for the moderate investor, and
10% for the aggressive investor type. Table 2 summarizes the strategic weights for the different
investor types. The maximum desired portfolio volatilities are set to 5%, 10%, and 15% for the
conservative, moderate, and aggressive investor clienteles, respectively, which is in line with
the historic volatilities of the strategically weighted portfolios for these investor types before
the evaluation period from 1988 to 1992. We employ these volatility bounds as constraints for
the optimization strategies. As for the optimized portfolios, both naïve-diversified portfolios are
rebalanced at every first trading day of each month. Rebalancing, however, only maintains the
naïve 1/N or strategic weight for each asset. As robustness check, we also compute equally and
strategically weighted buy-and-hold benchmark portfolios that do not include any rebalancing.
Our findings also hold for the buy-and-hold benchmark portfolios, and the performance differs
only marginally between the portfolios with and without rebalancing. To be parsimonious, we
only report the results with rebalancing.2
2.2 Minimum-variance portfolio

The minimum-variance (MinVar) strategy selects portfolio weights that minimize the variance
of the portfolio returns. The minimization problem is

min ω ω. (4)
ω
ˆ using rolling estima-

To implement this policy we rely on the sample covariance matrix
tion windows as described above. The advantage of the minimum-variance approach is that it
6 W. Bessler et al.
does not require any return estimates, which are usually subject to large estimation errors. The
effects of estimation errors in the covariance matrix are about 10 times smaller than the effects
of estimation errors in returns (Chopra and Ziemba 1993). In line with all other optimization
strategies, we include realistic investment constraints, specifically a budget restriction according
to Equation (1) and disallow short selling according to Equation (2).
2.3 Mean-variance (MV) optimized portfolio

In the MV approach (Markowitz 1952), the investor optimizes a trade-off between risk and
return. The mean-variance optimization problem is
δ
max U = ω μ − ω ω, (5)
ω 2
where U is the investor’s utility, μ is the vector of expected return estimates, and δ is the coef-
ficient of risk aversion. The Markowitz optimization framework assumes normally distributed
returns or mean-variance preferences, focusing only on the mean and variance of returns and
ignoring higher moments. Although this seems to be a critical assumption, Landsman and Nešle-
hová (2008) show that it is sufficient that returns are elliptically symmetrically distributed so
that all investor preferences are equivalent to mean-variance preferences. Therefore, it is rea-
sonable to rely on the mean-variance framework for portfolio optimization even if asset returns
are non-normal, but are symmetric. To implement the mean-variance strategy, we employ the
sample mean μ̂ and the sample covariance matrix ˆ as described above. We include a budget
restriction according to Equation (1), disallow short selling according to Equation (2), and limit
the maximum allowed portfolio volatility (Equation (3)). The risk aversion coefficient is initially
set to 2 and variations are analyzed as robustness check.
2.4 Bayes–Stein shrinkage portfolio

The Bayes–Stein (BS) approach is one of the most prominent extensions of MV and therefore
included in our analysis. The BS approach, proposed by Jorion (1985, 1986), is based on the
idea of shrinkage estimation by Stein (1955) and James and Stein (1961) and attempts to reduce
estimation error of the input parameters of MV by employing a Bayesian approach for estimating
returns and the covariance matrix. The optimization procedure is the same as in the MV approach
presented in Equation (5). The intuition of BS is to reduce estimation errors by shrinking the
sample mean μ̂ toward the expected return of the minimum-variance portfolio μ̂min with
1 −1
μ̂min = ŵmin μ̂ =
μ̂, (6)
1 −1 1

where 1 is a vector of ones and is the covariance matrix. BS shrinks the sample estimates by
using return estimates of the form:
N +2
μ̂BS = (1 − γ̂ )μ̂ + γ̂ μ̂min 1 with γ̂ = . (7)
−1 (μ̂ − μ̂min 1)
(N + 2) + K(μ̂ − μ̂min 1)
The BS approach estimates the covariance matrix as = ((K − 1)/(K − N − 2)), ˆ where
ˆ
μ̂ is the expected return of the minimum-variance portfolio, is the usual unbiased sample
min
covariance matrix, N is the number of assets included, and K is the sample size (Jorion 1986). In
addition to shrinking the return estimates, the Bayes–Stein approach also adjusts the covariance
matrix that we implement as described in Jorion (1986). We employ the same optimization pro-
cedure, optimization constraints, and estimation windows as for the MV approach and analyze
variations of all input parameters as a robustness check.
2.5 Black–Litterman portfolio

The BL model is an alternative approach for dealing with estimation errors in return estimates.
It combines two sources of information: ‘neutral’ (‘implied’) returns and ‘subjective’ return
estimates. The latter are also referred to as ‘views’. The advantage of the BL approach is that
investors can either provide return estimates for each asset or stay neutral for some assets they
feel less comfortable in making return forecasts. Moreover, the reliability of each return esti-
mate can be incorporated allowing investors to distinguish between qualified estimates and pure
guesses.
The basic idea is that investors should only depart from the reference portfolio, which might
be the market or any other benchmark portfolio, if they are able to provide reliable estimates of
future returns. The BL model uses implied returns as a prior that we compute based on the asset
weights of the reference portfolio. The implied excess returns used in the original Black and
Litterman (1992) approach are derived using reverse optimization, assuming that the observable
market or benchmark weights ω∗ are the result of a mean-variance optimization. Implied returns
used in the BL model are computed as

=δ ω∗ , (8)
e

where e is the vector of implied asset excess returns, is the covariance matrix, δ is the
investor’s risk aversion coefficient, and ω∗ is the vector of observable market or benchmark
weights.
The BL framework combines the vector of implied returns with the investor’s ‘views’
expressed in the vector Q, incorporating the reliability of each ‘view’ quantified in a matrix . To
derive the combined return estimates, the original Black and Litterman (1992) paper references
Theil’s mixed estimation model (1971). Figure 1 illustrates the procedure of the BL approach.
The combined return estimates are written as
μ̂BL = [(τ )−1 + P −1 P]−1 [(τ )−1

+ P −1 Q] (9)
in which P is a binary matrix containing the information for which asset a subjective return
estimate exists, and τ is a factor that measures the reliability of implied return estimates. The
combined return estimate is a matrix-weighted average of implied returns and ‘views’ with
respect to the correlation structure (Lee 2000). The weighting factors are the uncertainty mea-
sures of implied returns τ and subjective return estimates , which we discuss in the following
section.
In the BL approach, the posterior covariance matrix is (Satchell and Scowcroft 2000)

= +[(τ )−1 + P −1 P]−1 . (10)
BL
After computing combined return estimates and the posterior covariance matrix, a traditional
risk-return optimization is conducted maximizing the investor’s utility function presented in
Equation (5).
8 W. Bessler et al.
Figure 1. The procedure of the Black–Litterman approach (Idzorek 2005).
2.5.1 Implied returns and the parameter τ

The reference portfolio used to compute implied returns might have a strong influence on the
out-of-sample performance of the BL model. Therefore, we employ three alternative reference
portfolios: the 1/N portfolio (BL-1/N), the strategically weighted portfolio (BL-st.w.) described
in Section 2.1, and the minimum-variance portfolio (BL-MinVar) described in Section 2.2. The
minimum-variance portfolio might be particularly reasonable for conservative investors, as they
might prefer to invest in the lowest risk portfolio if the reliability of their return estimates is low.
However, for some portfolio managers it might be advantageous to stick to a certain benchmark
if return estimates are uncertain.
The parameter τ controls how distinctly the optimized portfolio may depart from the reference
portfolio. It reflects the uncertainty of implied returns and can be chosen based on a desired track-
ing error. Allaj (2013) provides a discussion of the parameter τ . For very small values (τ → 0)
the combined returns converge to implied returns and the BL optimized portfolio converges to
the reference portfolio. For large values (τ → ∞) the combined returns converge to the ‘views’
and the BL optimized portfolio converges to the MV portfolio in which the ‘views’ are the under-
lying return estimates. In the literature, the values used for τ typically range between 0.025 and
0.300 (Black and Litterman 1992; He and Litterman 1999; Drobetz 2001; Idzorek 2005). We start
with setting the parameter τ at a level of 0.100 and analyze variations in a sensitivity analysis.
2.5.2 ‘Subjective’ return estimates and their reliability

As described above, the BL model combines implied returns and subjective return estimates.
The literature on the BL model does not provide a clear answer how to derive subjective return
estimates and the reliability of these estimates. Several studies simply assume exogenously given
estimates (He and Litterman 1999; Lee 2000; Drobetz 2001; Idzorek 2005) and suggest confi-
dence intervals of the return estimates as a measure of uncertainty (Black and Litterman 1992).
Since the portfolio performance critically depends on the exogenously assumed estimates, these
approaches are hardly capable to evaluate the performance of the BL model in comparison
to MV and naïve-diversified benchmark portfolios. Moreover, mutually estimating returns and
their respective confidence intervals might be a challenging task for analysts and might hinder
a successful implementation of the BL model. Therefore, we employ sample means as subjec-
tive return estimates based on rolling estimation windows as in the other optimization models
(MV and BS). However, in contrast to MV and BS, the BL model additionally incorporates the
reliability of these estimates that are expressed in the matrix .
For a portfolio of N assets, is a N × N diagonal matrix with the reliability measures for
the assets on its diagonal. A low reliability in all ‘views’ results in optimized portfolio weights
close to the reference portfolio. Meucci (2010) proposes to assume simply an overall level of
confidence in the ‘views’ that is constant over time by setting as

1
= P P . (11)
c
In this approach, it is assumed that the reliability of ‘views’ is proportional to the reliability
of implied returns with the proportionality factor 1/c. As a result no additional and time-varying
information on the reliability of ‘views’ is included. We suggest that the out-of-sample perfor-
mance of the BL model is superior if reasonable and time-varying information on the reliability
of ‘views’ is included. Therefore, we measure the reliability of each ‘view’ i based on historic
forecast errors εi . For this, we employ the same rolling estimation windows as for return esti-
mates and estimate the uncertainty of return estimates as the variance of historic forecast errors.
We analyze different estimation window lengths as robustness check. The idea is that in uncer-
tain market environments when the last months return estimates differ strongly from the realized
returns, the reliability for the subsequent return estimate is likely to be lower, resulting in portfo-
lios closer to the reference portfolio. In contrast, in stable market conditions when the last months
return forecasts are close to the realized returns, the return estimate for the next period should be
more reliable and the optimized portfolio may depart more from the reference portfolio.
We analyze the contribution of this historic reliability measure by comparing the out-of-sample
portfolio performance of our approach with the assumption of an overall time-invariant level of
confidence in the ‘views’ as in Meucci (2010) by substituting according to Equation (11).
2.6 Performance measures

We calculate several performance measures to evaluate the optimized portfolios. First, we com-
pute the moments of the net portfolio returns (after transaction costs) for each optimization
strategy i. Further, we determine the out-of-sample net Sharpe ratio as the fraction of the out-
of-sample mean net excess return (mean return after transaction costs less risk-free rate) divided
by the standard deviation of out-of-sample net returns.
R̄Net,i − R̄f
ŜRi = . (12)
σ̂Net,i
Using Sharpe ratios as performance measure is often criticized, because asset return distri-
butions are usually non-normal. However, Meyer (1987) shows that the general LS condition
10 W. Bessler et al.
(location and scale) of returns is sufficient to rely on the μ-σ framework. Therefore, relying
on Sharpe ratios is reasonable even for asymmetric return distributions and fat tails as long as
the LS condition holds. We use the two-sample statistic to test if the difference in Sharpe ratios
of two portfolios is significant (Opdyke 2007). In contrast to earlier Sharpe ratio tests (Jobson
and Korkie 1981b; Lo 2002), this test is appropriate under very general conditions – stationary
and ergodic returns. Most important for our analysis, the test permits autocorrelated and non-
normal distributed returns and allows for a likely high correlation between the portfolio returns
of different strategies.3
As alternative performance measure, we compute the Omega ratio (Shadwick and Keating
2002) also referred to as gain-loss ratio. It measures the average gains to average losses in which
we define gains as returns above the risk-free rate and losses as returns below the risk-free rate.
Hence, investments with a larger Omega measure are preferable. Formally, the omega measure is

(1/T) Tt=1 max(0, rt,i − rf )
Omegai = , (13)
(1/T) Tt=1 max(0, rf − rt,i )
where ri,t is the return of asset i at time t and rf is the risk-free rate. The advantage of the Omega
measure is that it does not require any assumption on the distribution of returns.
As alternative risk measures besides volatility, we compute the maximum drawdown (MDD)
as proposed by Grossman and Zhou (1993). The MDD reflects the maximum accumulated loss
that an investor may suffer during the entire investment period if she buys the portfolio at a high
price and subsequently sells at the lowest price. As the Omega measure, it does not require any
assumption on the return distribution. We compute the percentage maximum drawdown (MDD)
of strategy i as

Pi,t − Pi,t∗
MDDi = Maxi,t∗∈(0,T) Maxi,t∈(0,t∗) , (14)
Pi,t
where Pi,t is the price of portfolio i at time t, when the portfolio is bought, and Pi,t∗ is the price
of portfolio i at time t*, when the portfolio is sold.
Furthermore, we compute the portfolio turnover, in line with Daskalaki and Skiadopoulos
(2011) and DeMiguel, Garlappi, and Uppal (2009), which quantifies the extent of trading required
to implement a certain strategy. The portfolio turnover PTi of strategy i is the average absolute
change of the portfolio weights ω over the T rebalancing points in time and across the N assets:
1
T N
PTi = (|ωi,j,t+1 − ωi,j,t+ |) (15)
T t=1 j=1
in which ωi,j,t is the weight of asset j at time t under strategy i; ωi,j,t+ is the portfolio weight before
rebalancing at t + 1; and ωi,j,t+1 is the desired portfolio weight at t + 1, after rebalancing. ωi,j,t
is usually different from ωi,j,t+ due to changes in asset prices between t and t + 1.
We account for trading costs by assuming proportional transaction costs of 30 basis points of
the transaction volume in the base case and compute all performance measures after transaction
costs. As a robustness check, we analyze the impact of different transaction costs.
3. Data
To construct multi-asset portfolios we include global stocks, bonds, and commodity indices in
the investment universe. We use the MSCI World and MSCI Emerging Markets stock indices
to cover both developed and emerging markets. Emerging markets usually provide higher stock
returns than developed markets because they have a higher exposure to additional risk factors
such as illiquidity or institutional and political conditions (Iqbal, Brooks, and Galagedera 2010).
Chiou, Lee, and Chang (2009) find that international diversification is beneficial for US investors,
reducing portfolio volatility, and improving risk-adjusted returns.
Government bond returns typically have low or even negative correlations with stock returns
and often prices of government bonds increase during stock market downturns. To ensure their
role as a low-risk investment we employ US government bonds, thereby eliminating default and
currency risks. To represent US government bond investments we rely on the Bank of Amer-
ica/Merill Lynch US Government Bond Index (all maturities). In addition, we include the Bank
of America/Merill Lynch US High Yield 100 Bond Index to add exposure to corporate default
risk. This index is expected to provide higher returns and higher risks compared to government
bonds, but lower returns and lower risks compared to stock indices.
The S&P GSCI Light Energy Index represents a diversified commodity investment, providing
investors with an exposure to a wide range of commodity price changes. While the main deter-
minants of the S&P GSCI Index are energy prices, the S&P GSCI Light Energy Index offers
more balance across different commodity classes. At the end of our sample period, it reflects
the price developments on the future markets for energy (37.4%), agricultural products (31.2%),
and livestock (10%), as well as industry (14%) and precious metals (7.4%). Commodities should
have low correlations with the traditional asset classes such as stocks and bonds, because their
prices depend on different risk factors such as weather, geographical conditions, and supply
constraints. Moreover, as several studies document a positive correlation between commod-
ity returns and future inflation, investing in commodities is often viewed as a hedge against
inflation (Bodie and Rosansky 1980; Erb and Harvey 2006; Gorton and Rouwenhorst 2006).
Several studies also find that by including commodities, the efficient frontier of stock-bond port-
folios improved (for instance, Satyanarayan and Varangis 1996; Abanomey and Mathur 1999;
Anson 1999; Jensen, Johnson, and Mercer 2000). More recent evidence suggests that diversifi-
cation benefits of commodities are regime-dependent (Cheung and Miu 2010), but that portfolio
benefits of commodities in out-of-sample optimized portfolios are ambiguous (Daskalaki and
Skiadopoulos 2011; You and Daigler 2013). However, given that investors still perceive com-
modities as an important asset class in portfolio optimization, we include commodities in our
analysis.
We obtain monthly total return index data for the period from January 1988 to December
2011 from Thomson Reuters Datastream. All data are denominated in US dollar. In line with
DeMiguel, Garlappi, and Uppal (2009), we use the three months US T-Bill rate as the risk-free
rate. Because we need several years of historical data to set up the first optimized portfolio the
evaluation period ranges from January 1993 to December 2011. Table 3 provides descriptive
statistics of the monthly asset returns for the full evaluation period.
The table shows similar annualized mean returns for stock and bond indices ranging from
6.16% to 8.00% p.a. For the entire period, the average return of the commodity index is slightly
lower than the average risk-free rate of 3.12%, resulting in a negative Sharpe ratio. The US
Government Bond Index generates the highest Sharpe ratio of 0.655. The maximum drawdowns
(MDD) of the assets reveal that the maximum loss an investor could have suffered during the
evaluation period by investing in stocks was between 55.16% and 63.04% of the invested cap-
ital. This figure was 59.95% for commodities, 27.21% for the US High Yield Bond Index, and
5.29% for the US Government Bond Index. The Jarque–Bera statistic is significant for all asset
Table 3. Descriptive statistics of asset returns (January 1993–December 2011).
US High Yield S&P GSCI

MSCI World MSCI EM US Gov. Bonds Bonds Light Energy
Mean return p.a. (%) 6.71 8.00 6.16 7.31 2.66

SD p.a. (%) 16.61 25.40 4.64 8.44 16.58
Skewness − 0.90 − 0.93 − 0.04 − 1.47 − 1.29
Kurtosis 5.34 5.93 4.26 10.44 8.45
Sharpe ratio 0.22 0.19 0.66 0.50 − 0.03
MDD (%) 55.16 63.04 5.29 27.21 59.95
JB 82.47* 114.61* 15.10* 608.24* 339.20*
Observations 228 228 228 228 228
Notes: This table provides sample moments, Sharpe ratios, maximum drawdown, and Jarque–Bera statistics
of the five asset classes considered in the empirical analysis. The period covers the months from January 1993
to December 2011. ‘Mean return p.a.’ denotes annualized time-series mean of monthly returns, while ‘SD
p.a.’ denotes the associated annualized standard deviation. ‘Skewness’ and ‘Kurtosis’ represent the third and
fourth moment of the return distribution. ‘Sharpe ratio’ shows the annualized Sharpe ratios of the respective
asset classes using the average 1993–2011 risk-free interest rate of 3.12% per year. MDD shows the maximum
drawdown of the respective asset class during the period from January 1993 to December 2011 and ‘JB’ is the
Jarque–Bera statistic for testing normality of returns.
*Statistically significant at the 1% level.
classes. Hence, the assumption of normal distributed returns has to be rejected. However, as men-
tioned above, Meyer (1987) shows that the general LS condition (location and scale) of returns
is sufficient to apply the mean-variance framework.
Table 4 presents evidence on potential diversification effects in terms of pair-wise correlation
coefficients. Over the entire period the diversification benefits when investing only in stocks
are limited. The correlation between the MSCI World and MSCI Emerging Markets is highly
significant and larger than 0.8, indicating a strong co-movement of developed and emerging
stock markets. While the US-High-Yield-Bond Index and commodities offer a slightly better
diversification effect with correlation coefficients ranging between 0.35 and 0.65, the highest
diversification potential during our sample period is provided by investing in the US Government
Bond Index, which is reflected in negative correlation coefficients and positive Sharpe ratios.
Consequently, we expect to find significant portfolio benefits by applying the BL, BS, and MV
frameworks on a multi-asset portfolio, including bonds and commodities, rather than on a stock-
only portfolio.
4. Empirical results
4.1 Results for the full sample
Table 5 summarizes the out-of-sample performance of the different asset allocation strategies for
the three investor types ‘conservative’, ‘moderate’, and ‘aggressive’ for the base case over the
full evaluation period from January 1993 to December 2011. In the base case, we use 36 months
rolling estimation windows for the covariance matrix and 12 months for return estimates. We
use shorter estimation windows for return estimates as we expect the correlation structure and
variances to be more stable. In robustness checks, we provide the results for different estimation
windows (5.2). The strategically weighted portfolio (st.w.) is computed according to the asset
weights in Table 2. Within the asset class ‘stocks’, the strategic weights are specified to be 25%
for emerging markets and 75% for developed markets. Accordingly, for the asset class ‘bonds’,
Table 4. Correlation matrix of asset classes (January 1993–December 2011).
US High Yield S&P GSCI

MSCI World MSCI EM US Gov. Bonds Bonds Light Energy
MSCI World 1
MSCI Emerging Markets 0.811* 1
US Gov. Bond Index − 0.182* − 0.221* 1
US High Yield Bond Index 0.652* 0.619* − 0.069 1
S&P GSCI Light Energy 0.470* 0.463* − 0.128** 0.353* 1
Notes: This table provides the correlation matrix for the asset classes considered in the analysis over the period from
January 1993 to December 2011.
*Statistically significant at the 1% level.
**Statistically significant at the 5% level.
the strategic weights are set to 75% for government bonds and to 25% for high-yield corpo-
rate bonds. In the equal-weighted (1/N) portfolio, all five asset classes obtain an equal portfolio
weight of 20%.
The performance evaluation in Table 5 reveals that the three BL approaches, with different
reference portfolios, yield larger Sharpe ratios and Omega measures than MV, BS, MinVar, and
both naïve-diversified portfolios for all investor types. The Sharpe ratios of the BL portfolios are
significantly larger (5% level) than that of the naïve-diversified 1/N strategy. In contrast, the MV
strategy does not result in a significant outperformance relative to the 1/N strategy.
Our results suggest that the impact of the reference portfolio on the performance of the BL
approach is rather low. For all analyzed reference portfolios, the BL optimization leads to a
consistently superior performance relative to MV, BS, and both naïve-diversified portfolios. This
result holds for all investor types. We also observe that for the conservative investor type, the BL-
MinVar approach performs slightly better than the other BL approaches. For aggressive investors,
however, the BL model based on strategic weights as reference portfolio performs marginally
better.
Our risk measures volatility and maximum drawdown (MDD) indicate a consistently lower
risk for all BL optimized portfolios in comparison to MV and BS, independent of the investor
type. At first, it seems surprising that the ex post realized volatilities differ from the ex ante
determined volatility constraints of 5%, 10%, and 15%, but the explanation is rather straightfor-
ward. On the one hand, the sample volatility estimates include estimation errors that may lead to
a discrepancy between ex ante estimated volatility and ex post realized volatility. On the other
hand, the optimization framework with volatility constraint as described in Equation (5) does
not necessarily favor the asset allocation with the largest possible volatility that is close to the
volatility constraint. The optimized portfolio is rather determined by the trade-off between risk
and return. For instance, in recessionary periods with negative expected stock returns, the opti-
mization framework is likely to allocate a large fraction of the portfolio to low-risk government
bonds, independent of the volatility constraint. Therefore, the average volatility over the entire
evaluation period is below the volatility constraint for all optimization models.
Table 5 also presents the average yearly portfolio turnover as an indicator for the magnitude
of trading volume and transaction costs required to implement a certain strategy. However, all
performance measures already include transaction costs. The results reveal that for all investor
types the BL approach requires a lower portfolio turnover and, therefore, has lower transaction
costs relative to the MV approach. ‘The BL-st.w.’ approach, for instance, yields an average yearly
14
Table 5. Empirical results for the full sample (evaluation period 1993–2011).
W. Bessler et al.
BL-st.w. BL-1/N BL-MinVar BS MV Min Var st.w. 1/N st.w. B&H 1/N B&H
Investor type: conservative

Net mean return p.a. (%) 7.81 7.79 7.86 7.31 7.29 6.09 6.29 6.08 6.51 6.25
Volatility p.a. (%) 5.16 5.22 5.13 5.27 6.08 4.17 4.86 11.08 5.07 11.08
Net Sharpe ratio 0.91†† 0.89†† 0.92†† 0.79†† 0.68 0.71 0.65 0.27 0.67 0.28
Net Omega measure 1.96 1.93 1.98 1.78 1.69 1.70 1.66 1.24 1.67 1.25
Net MDD (%) 5.99 6.07 6.17 7.30 9.41 7.45 13.99 40.59 14.19 40.50
VaR99% (%) 2.77 3.04 2.87 3.33 3.92 2.74 3.16 9.72 9.70 12.33
Avrg. number of assets 3.32 3.79 3.20 2.91 2.69 3.71 5.00 5.00 5.00 5.00
Avrg. turnover p.a. 2.13 2.06 2.11 1.96 2.67 0.77 0.18 0.29 0.00 0.00
Investor type: moderate
Net mean return p.a. (%) 9.58 9.51 9.28 8.27 8.21 – 6.03 6.08 6.39 6.25
Volatility p.a. (%) 8.65 8.87 8.05 9.40 10.37 – 9.16 11.08 9.52 11.08
Net Sharpe ratio 0.75∗∗##†† 0.72†† 0.76†† 0.55 0.49 – 0.32 0.27 0.34 0.28
Net Omega measure 1.77 1.73 1.81 1.48 1.46 – 1.27 1.24 1.31 1.25
Net MDD (%) 9.46 11.02 9.21 14.35 16.18 – 35.10 40.59 35.30 40.50
VaR99% (%) 6.36 6.91 5.52 6.87 7.53 – 7.65 9.72 − 9.70 − 12.33
Avrg. number of assets 3.26 3.48 2.86 2.33 2.16 – 5.00 5.00 5.00 5.00
Avrg. turnover p.a. 3.32 3.29 3.28 3.34 4.44 – 0.27 0.29 0.00 0.00
Investor type: aggressive
Net mean return p.a. (%) 11.72##†† 11.32##†† 10.37##†† 9.46 10.35 – 5.81 6.08 6.27 6.25
Volatility p.a. (%) 11.68 11.30 9.85 12.38 13.62 – 14.27 11.08 14.74 11.08
Net Sharpe ratio 0.74#†† 0.73##†† 0.74##†† 0.51 0.53 – 0.19 0.27 0.21 0.28
Net Omega measure 1.79 1.78 1.82 1.51 1.53 – 1.15 1.24 1.18 1.25
Net MDD (%) 14.39 11.67 12.10 22.23 24.59 – 50.99 40.59 52.04 40.50
VaR99% (%) 9.43 7.86 6.73 10.26 10.77 – 12.38 9.72 − 9.70 12.33
Avrg. number of assets 3.12 3.21 2.63 1.86 1.72 – 5.00 5.00 5.00 5.00
Avrg. turnover p.a. 3.62 3.83 3.89 4.76 4.61 – 0.25 0.29 0.00 0.00
Notes: This table reports the portfolio performance measures for the full sample from 1993 to 2011 in the base case. In all optimized portfolios, the maximum expected
volatility is constrained to 5%, 10%, and 15% p.a. for the conservative, moderate, and aggressive investor type, respectively. All portfolios are rebalanced at the first trading
day of every month. */**, # /## , † /†† indicate a significantly higher Sharpe ratio compared to mean-variance, the strategically weighted benchmark, and the 1/N benchmark at
the significance levels of 1% and 5%, respectively.
turnover equal to 3.32 times the portfolio volume for the moderate investor, while the yearly
turnover for MV equals 4.44 times the portfolio volume. The explanation for this result is that
the combined return estimates used in the BL approach are more stable over time than the sample
means used in MV, which is indicated by a lower variance of return estimates (unreported).
Additionally, we find that the average number of assets in the optimized portfolio, as an indi-
cator for the magnitude of diversification across asset classes, is higher for BL than for MV and
BS portfolios. Consequently, BL portfolios offer more diversification across asset classes and
have less extreme allocations. A possible explanation is that the combined return estimates used
in the BL approach are less heterogeneous. Figure 2 presents the optimized portfolio weights for
BL and MV optimization for the three investor types during the 1993–2011 period. In line with
the turnover and diversification measures, the figure reveals less extreme portfolio reallocations
and a stronger benchmark orientation of the BL optimized portfolios relative to MV.
Our findings for the multi-asset data set suggest a slight outperformance of the sample-based
MV approach relative to naïve-diversified strategies. In line with Kirby and Ostdiek (2012), the
level of outperformance (after transaction costs) of MV is insignificant. However, our findings
differ from that of DeMiguel, Garlappi, and Uppal (2009) and Murtazashvili and Vozlyublennaia
(2013) who conclude that none of the variations of MV is able to outperform a naïve 1/N
strategy. One explanation is the difference in the employed data set. While both earlier stud-
ies analyze stock-only portfolios, we additionally include government bonds, corporate bonds,
and commodities that should result in broader diversification and might enhance the portfolio
optimization benefits. Particularly, by including government bonds, asset allocation models may
outperform naïve strategies if they actively shift wealth from stocks to bonds during stock mar-
ket downturns and vice versa. In fact, Figure 2 shows that for both, BL and MV, and across all
investor types, the optimized portfolios are shifted completely to government bonds during the
stock market downturns between 2000 and 2003 (end of the new economy period) and between
2008 and 2009 (the financial crisis).
However, while the multi-asset approach might explain why MV performs superior in our
analysis relative to the DeMiguel, Garlappi, and Uppal (2009) study, additional analyses are
required to explain the reasons for the performance differences between BL, BS, and MV
approaches. To obtain additional insights, we analyze the return estimates used in the opti-
mization approaches. We find that for all assets the forecast error of estimated to subsequently
realized returns, measured as mean absolute error (MAE), is consistently lower for mixed return
estimates employed in the BL approach than for return estimates employed in the BS and MV
approaches. Additionally, we compute the coefficients of determination (R2 ) as the squared cor-
relation between forecasted and subsequently realized returns and use it as an indicator for the
ex post performance. In line with the results for the MAE, we find that the coefficients of deter-
mination of forecasted returns to subsequently realized returns are larger for BL mixed return
estimates than for BS shrinked return estimates and for sample mean returns employed in MV.
The analyses of forecast errors are available from the authors upon request.
4.2 Performance of optimized portfolios in different market environments

To offer additional explanations for the performance of the asset allocation strategies in different
market environments, we divide the full evaluation period (1993–2011) into several sub-periods.
Expansionary and recessionary sub-periods are determined on an ex ante basis from monetary
policy and stock market signals. We combine both approaches to reduce the number of sub-
periods as well as the probability of incorrect signals (Bessler, Holler, and Kurmann 2012). The
Figure 2. BL and MV optimized portfolio weights (base case).

Notes: This figure reports the optimized portfolio weights for the full sample from 1993 to 2011 in the base
case. The optimized portfolios are constraint to a maximum expected volatility of 5%, 10%, and 15% for
the conservative, moderate, and aggressive investor type, respectively. All portfolios are rebalanced at the
first trading day of every month.
monetary cycle is the first change of the short-term interest rate by the central bank that runs
counter to the previous trend (Jensen and Mercer 2003). The stock market signal is determined
as the intersection of the 24-months moving average of the MSCI World with the actual index
from either below (expansionary state) or above (recessionary state), indicating a change in the
business cycle. For the transition from one state to another, it is required that both instruments,
the monetary policy and the stock market, provide a consistent signal. In Figure 3, we present
the definition of sub-periods derived from the joint monetary policy and stock market signals,
where shaded areas denote recessionary periods.
The first sub-period ranges from January 1993 to January 2001 and includes a number of
events such as the Asian crisis, the Russian default, and the buildup of the new economy bubble.
Figure 3. Definition of sub-periods.

Notes: The figure shows the definition of individual sub-periods conditional on monetary policy signals as
well as stock market signals. Shaded areas denote down markets/recessionary periods.
This period consists of 97 months and can be characterized as ‘expanding’ with increasing values
in developed stock markets and relatively high interest rates with T-Bills yielding, on average,
4.77% p.a. The second sub-period between February 2001 and June 2004 covers the end of the
new economy period and the subsequent rebound of international stock markets. It includes 41
months and is characterized as ‘recessionary’ with bearish stock markets and an average risk-
free rate of 1.85% p.a. The third sub-period ranges from July 2004 to February 2008 covering 44
months, and containing bullish stock markets and high interest rates. The average risk-free rate
in this period is 3.67% p.a. The final sub-period from March 2008 to December 2011 includes
46 months and incorporates the financial crisis that led to substantial declines in the values of
equities and alternative asset classes, such as commodities and hedge funds. The average risk-
free rate in the fourth period was only 0.37% p.a.
The performance of the out-of-sample optimized portfolios for the four sub-periods is sum-
marized in Table 6 for the moderate investor.4 We find that BL optimized portfolios outperform
BS and MV in all four sub-periods and perform superior than naïve-diversified portfolios in
three of four sub-periods. For both recessionary sub-periods, we observe substantially higher
Sharpe ratios for the BL strategies relative to MV. Naturally, due to the shorter time series of sub-
periods, the power of the significance test is lower relative to the full period so that differences
in Sharpe ratios are not significant at the 5% level anymore. In comparison to Bayes–Stein and
both naïve-diversified portfolios, all BL approaches achieve a substantially higher performance
in both recessionary periods.
In contrast, for both expansionary periods we find a relatively smaller outperformance of BL
in comparison to MV and BS. In the third sub-sample, which covers the bullish stock mar-
kets between July 2004 and February 2008, the naïve-diversified portfolios outperform all other
optimization strategies (BL, BS, MV, and MinVar).
For all sub-periods, the BL optimized portfolios are less risky than BS, MV, and both naïve-
diversified portfolios. This is indicated by a lower maximum drawdown and is consistent with
Table 6. Analysis of sub-periods.
BL-st.w. BL-1/N BL-MinVar BS MV MinVar st.w. 1/N
January 1993–January 2001

Net mean return p.a. (%) 10.25 10.02 9.97 10.93 10.41 6.78 7.86 6.74
Volatility p.a. (%) 9.16 9.51 8.07 10.34 11.08 3.92 6.90 8.30
Net Sharpe ratio 0.60 0.55 0.65 0.60 0.51 0.51 0.45 0.24
Net MDD (%) 9.46 9.03 9.21 11.42 12.93 5.72 15.32 19.41
Avrg. number of assets 2.95 3.21 2.70 2.35 2.09 3.70 5.00 5.00
Avrg. turnover p.a. 4.16 4.03 4.04 2.95 5.48 0.83 0.22 0.26
Avrg. risk rate 4.77% 4.77% 4.77% 4.77% 4.77% 4.77% 4.77% 4.77%
Obs. 97 97 97 97 97 97 97 97
February 2001–June 2004
Volatility p.a. (%) 6.40 6.54 6.02 7.60 8.05 4.84 8.32 10.00
Net Sharpe ratio 0.92 0.83 1.04** 0.45 0.39 0.85 0.22 0.33
Net MDD (%) 6.52 7.08 4.88 9.43 10.67 3.40 14.19 17.37
Avrg. turnover p.a. 2.67 3.12 1.95 4.03 4.42 0.62 0.30 0.31
Avrg. risk-free rate 1.85% 1.85% 1.85% 1.85% 1.85% 1.85% 1.85% 1.85%
Obs. 41 41 41 41 41 41 41 41
July 2004–February 2008
Volatility p.a. (%) 9.41 9.54 9.38 9.42 11.35 2.80 5.08 6.66
Net Sharpe ratio 1.08 1.09 1.03 0.75 0.73 1.05 1.35 1.32
Net MDD (%) 6.63 6.69 7.25 8.98 10.48 6.65 34.14 39.57
Avrg. turnover p.a. 3.45 3.24 4.08 4.24 4.20 0.97 0.22 0.25
Obs. 44 44 44 44 44 44 44 44
March 2008–December 2011
Net mean return p.a. (%) 5.84 6.21 5.06 3.17 3.00 4.31 0.14 − 0.43
Volatility p.a. (%) 8.63 8.73 8.28 8.79 9.75 5.08 15.04 18.10
Net Sharpe ratio 0.63 0.67 0.57 0.32 0.27 0.78 − 0.01 − 0.04
Net MDD (%) 9.34 11.02 6.90 14.35 16.18 7.45 35.10 40.59
Avrg. turnover p.a. 2.02 1.97 2.10 2.10 2.57 0.59 0.39 0.38
Obs. 47 47 47 47 47 47 47 47
Notes: This table reports portfolio performance measures for the four sub-periods from 1993 to 2011 for the moderate
investor type. In all optimized portfolios, the maximum expected volatility is constrained to 10% p.a. All portfolios
are rebalanced at the first trading day of every month. */** Indicate a significantly higher Sharpe ratio compared to
mean-variance at the significance levels of 1% and 5%, respectively.
the analysis of the full sample. Furthermore, the analysis reveals consistently lower portfolio
turnovers and, hence, lower transaction costs for BL compared to MV for all sub-periods. Addi-
tionally, for all sub-periods BL portfolios are more diversified across asset classes than MV and
BS portfolios as indicated by a higher average number of assets in the optimized portfolios. Over-
all, our results suggest that the BL model outperforms MV, BS, and naïve-diversified portfolios
particularly in recessionary periods. The explanation is that the BL model reacts more quickly to
changes in the economic cycle and adjusts the asset allocation more rapidly.
5. Robustness checks
We perform a variety of robustness checks and sensitivity analyses to confirm the robustness of
our results. We vary the constraints on optimized portfolio weights and relax the short selling
constraint (Section 5.1). We analyze variations in all input parameters (Section 5.3) and estima-
tion windows (Section 5.2) and modify the level of transaction costs and, alternatively, include
transaction costs in the optimization function (Section 5.4). Finally, we alter the investment uni-
verse and employ different sets of assets (Section 5.5). We primarily report the results for the
BL-st.w. strategy because the results for the other reference portfolios used in the BL approach
(st.w., 1/N, MinVar) are qualitatively similar. The same applies for the three investor types in that
we focus on the moderate investor type, as the results for the others are similar. All unreported
results are available upon request.
5.1 Alternative optimization constraints

5.1.1 Restrictions on optimized portfolio weights

It is possible that the portfolio composition of the benchmark differs substantially from the allo-
cation of the optimized portfolios and consequently the naïve-diversified benchmark portfolio
is inappropriate. Therefore, we repeat the optimizations relative to the strategically weighted
benchmark and restrict the optimized portfolio weight for each asset so that the maximum abso-
lute deviation from the benchmark weight reported in Table 2 does not exceed a certain threshold.
This is an approach frequently used by practitioners to cope with the shortcomings of MV opti-
mization. Table 7 presents the results for a maximum absolute deviation from the benchmark
weight of 15% points. The results confirm our findings for the base case. This holds for the
out-of-sample Sharpe ratios as well as for the portfolio risk (MDD), the portfolio diversification,
and the portfolio turnover. Intuitively, restricting asset weights lowers the portfolio turnover and
increases the average number of assets in the portfolios for all strategies.5
5.1.2 Short selling constraint

To investigate whether our findings are sensitive to the short selling constraint, we allow for short
positions in the optimization. The new results (unreported) confirm that the BL approach yields
superior portfolio performance (Sharpe ratios and Omega measures) with lower risk (volatility,
MDD, value-at-risk) compared to MV and BS approaches. When short selling is feasible the
performance of all optimization strategies improves despite higher turnover and transaction costs.
5.1.3 Volatility constraint

Next, we vary the portfolio volatility restriction, while keeping the strategic weights of stocks,
bonds, and commodities constant at the level of 40%, 45%, and 15% (moderate portfolio accord-
ing to Table 2), respectively. Panel A of Table 8 shows that our results are robust for volatility
constraints between 5% and 20%. This holds for the out-of-sample Sharpe ratios, the portfolio
risk (MDD), the portfolio diversification, and the portfolio turnover.
5.1.4 Variations of the risk aversion parameter

The results for variations of the risk aversion coefficient between 0.5 and 10.0 we report in panel
B of Table 8. Again, we find that our results are robust to different risk aversion coefficients. This
holds for the out-of-sample Sharpe ratios, the portfolio risk (MDD), the portfolio diversification,
Table 7. Restriction of optimized portfolio weights.
Conservative
Net Sharpe ratio 0.95† 0.86† 0.91† 0.77†† 0.73†† 0.74†† 0.65 0.27
Net Omega measure 2.02 1.88 1.97 1.77 1.71 1.73 1.66 1.24
Net MDD (%) 7.86 8.46 6.49 9.76 10.83 7.67 13.99 40.59
Avrg. turnover p.a. 1.11 1.00 0.99 1.36 1.53 0.51 0.18 0.29
Moderate
Net Sharpe ratio 0.64##† 0.65##† 0.62##† 0.52†† 0.49 – 0.32 0.27
Net Omega measure 1.60 1.62 1.62 1.48 1.44 – 1.27 1.24
Net MDD (%) 21.84 20.46 19.33 25.02 25.99 – 35.10 40.59
Avrg. number of assets 4.45 4.48 4.31 3.91 3.88 – 5.00 5.00
Avrg. turnover p.a. 1.44 1.32 1.42 1.80 1.87 – 0.27 0.29
Aggressive
Net Sharpe ratio 0.40## 0.41## 0.44∗∗## 0.25 0.31 – 0.19 0.27
Net MDD (%) 40.37 39.87 38.61 43.31 43.33 – 50.99 40.59
Avrg. turnover p.a. 1.49 1.44 1.46 1.89 1.64 – 0.25 0.29
Notes: This table reports the portfolio performance measures for the full sample from 1993 to 2011. In all optimized
portfolios, the asset weights are restricted to a maximum absolute deviation of 15% from the respective benchmark
weight reported in Table 2. The maximum expected volatility is constrained to 5%, 10%, and 15% p.a. for the
conservative, moderate, and aggressive investor type, respectively. All portfolios are rebalanced at the first trading
day of each month. */**, # /## , † /†† indicate a significantly higher Sharpe ratio compared to mean-variance, the
strategically weighted benchmark, and the 1/N benchmark at the significance levels of 1% and 5%, respectively.
as well as the portfolio turnover. The BL model performs best for risk aversion coefficients
between 2 and 4, which is in line with the assumed moderate investor type.
5.2 Alternative estimation windows

Panels C and D of Table 8 present the results for different estimation windows for the covariance
matrix and the return estimates. In line with the base case results, we find consistently higher
net Sharpe ratios for the BL approach in comparison to MV and both naïve-diversified port-
folios for all analyzed estimation windows. The results are insignificant for much shorter and
longer estimation windows. The portfolio turnover increases dramatically for very short estima-
tion windows (one to six months), resulting in substantial transaction costs and a relatively lower
performance compared to the naïve-diversified portfolios. For long estimation windows ( ≥ 36
months for returns), the responsiveness to structural breaks such as stock market downturns is
reduced, resulting in lower out-of-sample Sharpe ratios for all optimization approaches. An anal-
ysis of the autocorrelation functions of the asset returns confirms that only the last months returns
are significantly correlated with current returns, while returns with a lag longer than 12 months
hardly provide any explanatory power.
We identify optimal estimation windows between 36 and 48 months for the covariance matrix
and around 12 months for the return estimates for the BL approach. The insignificant results of
the BL model for very long and very short return estimation windows highlight the importance
of accurate and responsive return estimates. However, further research is required to analyze the
performance of the BL approach for alternative return estimates.
Table 8. Variation of optimization constraints, risk aversion coefficients, and estimation windows.
5.00% 7.50% 10% 15% 20% Benchmark
Maximum
volatility p.a. BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV st.w. 1/N
Panel A: Variation of optimization constraint: maximum allowed portfolio volatility

Net Sharpe ratio 0.92##† 0.79##†† 0.68 0.80∗∗##†† 0.63 0.54 0.75∗∗##†† 0.55 0.49 0.75∗∗##†† 0.51 0.53 0.74##†† 0.50 0.49 0.32 0.27
Net MDD (%) 5.88 9.30 9.41 7.58 9.82 11.54 9.46 14.35 16.18 11.18 22.23 24.59 16.41 27.90 27.98 35.10 40.59
Avrg. number of 3.64 2.91 2.69 3.45 2.59 2.41 3.26 2.33 2.16 3.00 1.86 1.71 2.76 1.52 1.35 5.00 5.00
assets
Avrg. turnover 2.00 1.96 2.67 2.80 2.78 3.79 3.32 3.34 4.44 3.91 3.80 4.61 4.07 3.61 4.36 0.27 0.29
p.a.
Panel B: Variation of risk aversion coefficient
0.5 1 2 4 8 Benchmark
Delta BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV st.w. 1/N
Net Sharpe ratio 0.61 0.54 0.47 0.68 0.54 0.48 0.75∗∗##†† 0.55 0.49 0.78∗∗##†† 0.53 0.50 0.69##†† 0.58 0.48 0.32 0.27
Net MDD 11.62% 14.35% 16.18% 10.35% 14.35% 16.18% 9.46% 14.35% 16.18% 9.94% 14.35% 16.18% 18.59% 10.93% 15.81% 35.10% 40.59%
Avrg. number of 2.79 2.31 2.17 2.95 2.31 2.16 3.26 2.33 2.16 3.93 2.35 2.19 4.53 2.42 2.25 5.00 5.00
assets
The European Journal of Finance

Avrg. turnover 3.72 3.48 4.48 3.62 3.38 4.49 3.32 3.34 4.44 2.74 3.32 4.44 2.04 3.36 4.35 0.27 0.29
p.a.
Panel C: Variation of estimation window for covariance matrix
Estimation 12 24 36 48 60 Benchmark
window
number of
months BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV st.w. 1/N
Net Sharpe ratio 0.63 0.66 0.56 0.73∗∗##†† 0.58 0.48 0.75∗∗##†† 0.55 0.49 0.75∗∗##†† 0.42 0.46 0.73†† 0.44 0.47 0.32 0.27
Net MDD 16.13% 10.18% 18.28% 14.58% 14.04% 15.73% 9.46% 14.35% 16.18% 8.97% 17.55% 16.99% 8.76% 16.82% 18.26% 35.10% 40.59%
Avrg. number of 3.04 2.37 1.90 3.14 2.16 2.09 3.26 2.33 2.16 3.38 2.38 2.24 3.41 2.50 2.29 5.00 5.00
assets
Avrg. turnover 4.34 3.29 4.63 3.56 2.86 4.33 3.32 3.34 4.44 3.48 3.51 4.60 3.27 3.31 4.59 0.27 0.29
p.a.
(Continued).
21
22
W. Bessler et al.
Table 8. Continued.
5.00% 7.50% 10% 15% 20% Benchmark
Maximum
volatility p.a. BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV st.w. 1/N
Panel D: Variation of estimation window for historic return estimates

Estimation 1 6 12 18 36 Benchmark
window
number of
months BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV st.w. 1/N
Net Sharpe ratio 0.45 0.26 0.23 0.57 0.53 0.32 0.75∗∗##†† 0.55 0.49 0.56 0.43 0.33 0.48 0.44 0.34 0.32 0.27
Net MDD 14.48% 19.59% 22.69% 15.65% 15.69% 24.93% 9.46% 14.35% 16.18% 17.45% 19.44% 20.58% 28.95% 22.70% 30.87% 35.10% 40.59%
Avrg. number of 2.97 2.10 2.01 3.10 2.26 2.15 3.26 2.33 2.16 3.38 2.24 2.13 3.69 2.17 2.03 5.00 5.00
assets
Avrg. turnover 12.30 14.44 15.29 4.76 5.68 6.41 3.32 3.34 4.44 2.92 2.45 4.07 1.81 2.64 2.80 0.27 0.29
p.a.
Notes: The table shows sensitivity analysis for different optimization constraints, risk aversion coefficients, and estimation windows for the moderate investor type and the full
sample from 1993 to 2011. ∗ /∗∗ , # /## , † /†† indicate a significantly higher Sharpe ratio compared to mean-variance, the strategically weighted benchmark, and the 1/N benchmark
at the significance levels of 1% and 5%, respectively.
Relative to BS, the BL approach performs consistently superior with one exception: for a 12-
months estimation window for the covariance matrix, the BS approach achieves a slightly higher
Sharpe ratio than BL. However, further analysis suggests that this result is due to inflating the
covariance matrix in the BS model, which is equivalent to reducing the volatility constraint to
6.74%.6 With a volatility constraint of 6.74%, the BL and MV approaches yield a Sharpe ratio of
0.83 and 0.56 (unreported), respectively. Hence, when comparing equally constrained portfolios,
the BL approach outperforms BS and MV, which confirms our base case results.
5.3 Varying BL model parameters τ and

We present the results for variations of the BL parameters τ and in Table 9. The MV, BS,
and naïve-diversified portfolios are insensitive to alternative values of τ and and, hence, are
constant in this analysis. First, we vary the parameter τ in the BL model that captures the confi-
dence in implied returns. For values of τ close to zero, the unconstrained optimized BL portfolio
converges to the benchmark portfolio. In contrast, for very large values of τ , the optimized BL
portfolio converges to the MV optimized portfolio. Panel A of Table 9 shows that for the com-
monly used values for τ between 0.025 and 1.00 (Black and Litterman 1992; He and Litterman
1999; Drobetz 2001; Idzorek 2005), our results are robust. This holds for the out-of-sample
Sharpe ratios as well as for the portfolio risk (MDD), the portfolio diversification, and the port-
folio turnover. Furthermore, we observe that the BL portfolio’s deviation from the benchmark
declines with lower values of τ , which results in declining tracking errors. This is consistent with
the interpretation of τ as an uncertainty measure of implied returns and confirms its function to
control the desired deviation from the reference portfolio.
Second, we vary the estimation window for , which quantifies the reliability of ‘views’ based
on the historic estimation errors of return forecasts. Panel B of Table 9 confirms that our results
are robust for estimation windows of between 6 and 36 months. Third, we assume an overall
time-invariant level of confidence in the ‘views’ (Meucci 2010) by substituting according
to Equation (11). In the approach no additional time-varying information on the reliability of
‘views’ is included. Panel C of Table 9 presents the results for different overall time-invariant
levels of confidence, measured by the scalar c. We find that for all confidence levels (scalars c
between 0.1 and 100), the outperformance of the BL model relative to MV vanishes. Therefore, it
seems that including time-varying information on the reliability of return estimates is an essential
factor for the superior performance of the BL model relative to MV. This leads, on the one hand,
to an investment close to the reference portfolio when market conditions are uncertain and, on
the other hand, to larger deviations from this reference portfolio when markets are more stable
and return forecasts are more reliable.
5.4 The impact of transaction costs

To analyze the impact of transaction costs, we first vary the variable transaction costs between
0 and 50 basis points and then include variable transaction costs in the optimization function.
The net Sharpe ratio measures for different levels of transaction costs are provided in Table 10.
We find that for all analyzed levels of transaction costs, the BL portfolios outperform all other
strategies and perform consistently better than MV and both naïve-diversified portfolios.
24
Table 9. Variation of BL model parameters.
Panel A: Variation of level of confidence of implied returns (τ )
W. Bessler et al.
BS MV BL-st.w.: varying parameter τ st.w.
Parameter τ n/a (τ → ∞) 1 0.3 0.15 0.1 0.05 0.025 (τ → 0)

Net Sharpe ratio 0.55 0.49 0.67 0.67 0.71##†† 0.75∗∗##†† 0.77∗∗##†† 0.51 0.32
Net MDD (%) 14.35 16.18 10.79 10.01 9.58 9.46 10.34 15.74 35.10
Avrg. number of assets 2.33 2.16 2.72 2.86 3.06 3.26 3.87 2.34 5.00
Avrg. turnover p.a. 3.34 4.44 4.01 3.88 3.56 3.32 2.79 4.45 0.27
Tracking error (%) 2.17 2.50 2.34 2.20 2.12 2.03 1.68 2.40 –
Panel B: Variation of estimation window for uncertainty measure of views ()
BS MV BL-st.w varying estimation window for st.w

Estimation window size (months)
for estimating the uncertainty of views n/a ( → 0) 3 6 12 18 24 36 ( → ∞)
Net Sharpe ratio 0.55 0.49 0.52 0.68 0.75∗∗##†† 0.73†† 0.76##†† 0.74†† 0.32
Net MDD (%) 14.35 16.18 13.01 13.66 9.46 10.53 10.64 11.08 35.10
Avrg. turnover p.a. 3.34 4.44 6.28 4.28 3.32 3.10 2.98 2.98 0.27
Tracking error (%) 2.17 2.50 2.17 2.18 2.03 2.07 2.09 2.07 –
Panel C: Variation of assumed overall level of confidence in views (c)
BS MV BL-st.w varying overall confidence level c for views st.w
Parameter c n/a (τ → ∞) 0.1 2 5 10 20 100 (τ → 0)
Net Sharpe ratio 0.55 0.49 0.46 0.52 0.51 0.52 0.51 0.49 0.32
Net MDD (%) 14.35 16.18 29.13 15.68 15.60 15.74 15.88 16.09 35.10
Avrg. turnover p.a. 3.34 4.44 1.14 4.07 4.38 4.44 4.47 4.44 0.27
Tracking error (%) 2.17 2.50 0.51 2.02 2.23 2.33 2.37 2.42 –
Notes: The table shows sensitivity analyses for setting different model parameters in the BL model for the moderate investor type and the full sample from 1993 to 2011. The
strategically weighted benchmark is the reference portfolio for BL and is used to compute tracking errors. */**, # /## , † /†† indicate a significantly higher Sharpe ratio compared
to mean-variance, the strategically weighted benchmark, and the 1/N benchmark at the significance levels of 1% and 5%, respectively.
Table 10. The influence of transaction costs.

Variable transaction
costs in basis points BL-st.w. BL-1/N BL-MinVar BS MV st.w. 1/N MinVar
5 0.85##†† 0.82##†† 0.87##†† 0.64 0.61 0.32 0.27 0.76##††

10 0.83##†† 0.80##†† 0.85##†† 0.62 0.58 0.32 0.27 0.75#††
20 0.79##†† 0.76##†† 0.81##†† 0.59 0.54 0.32 0.27 0.73#††
30 0.75∗∗##†† 0.72†† 0.76†† 0.55 0.49 0.32 0.27 0.71#††
40 0.71∗∗†† 0.68∗∗†† 0.72†† 0.51 0.45 0.31 0.26 0.69#†
50 0.67∗∗ 0.64** 0.68 0.47 0.40 0.31 0.26 0.67#†
Notes: The table shows a sensitivity analysis for different levels of transaction costs for the moderate investor type
and the full sample from 1993 to 2011. */**, # /## , † /†† indicate a significantly higher Sharpe ratio compared to mean-
variance, the strategically weighted benchmark, and the 1/N benchmark at the significance levels of 1% and 5%,
respectively.
Alternatively, we include variable transaction costs in the optimization function. The opti-
mization problem with transaction costs is
δ
max U = ω μ − ϕ − ω ω, (16)
ω 2
where is a vector that contains the changes in portfolio weights required to rebalance the
portfolio at the monthly rebalancing dates, and ϕ is the vector of variable transaction costs of
the assets. The results in Table 11 confirm our findings for the base case. This holds for the
out-of-sample Sharpe ratios as well as for the portfolio risk (MDD), the portfolio diversification,
and the portfolio turnover. As expected, including transaction costs in the optimization function
substantially reduces portfolio turnover for all optimization strategies and it slightly enhances
performance after transaction costs for most strategies.
5.5 Alternative asset universes

To check whether our results are robust to different sets of assets, we repeat our analysis
using different and larger asset universes. First, we include two alternative multi-asset portfo-
lios containing a larger number of stock indices. Second, we employ stock-only portfolios as in
DeMiguel, Garlappi, and Uppal (2009) to investigate the benefits of additional asset classes
such as bonds and commodities for our asset allocation models relative to naïve-diversified
portfolios. The multi-asset portfolios include a larger number of stock indices denominated in
USD and Euro, reflecting USD and Euro investors. The USD multi-asset portfolio contains eight
MSCI stock indices (France, Germany, UK, Canada, USA, Italy, Japan, and Switzerland), com-
plemented by US government bonds (Datastream Government Bond Index) and commodities
(S&P GSCI). The evaluation period is 1993–2011. The Euro multi-asset universe includes Euro-
pean government bonds, European corporate high-yield bonds, as well as four currency-hedged
regional stock indices (MSCI Europe, MSCI North America, MSCI Pacific, and MSCI Emerging
Markets) and the Euro-currency-hedged S&P GSCI commodity index. Based on the availability
of data, the evaluation period is 1999–2011.
The first stock-only portfolio is based on international country indices (International Stocks)
and includes eight MSCI stock indices (France, Germany, the UK, Canada, the USA, Italy, Japan,
and Switzerland) as in DeMiguel, Garlappi, and Uppal (2009). The second stock-only portfolio
Table 11. Considering transaction costs in the optimization function.
Conservative
Net Sharpe ratio 0.96† 0.86†† 0.92†† 0.82†† 0.73 0.64 0.65 0.27
Net Omega measure 2.03 1.90 1.99 1.85 1.72 1.61 1.66 1.24
Net MDD (%) 6.50 6.69 6.09 7.35 7.80 8.35 13.99 40.59
Avrg. turnover p.a. 0.73 0.82 0.82 1.58 2.16 0.21 0.18 0.29
Moderate
Net Sharpe ratio 0.76##† 0.83##†† 0.85##†† 0.50 0.50 – 0.32 0.27
Net MDD (%) 13.89 8.45 7.56 13.75 16.18 – 35.10 40.59
Avrg. turnover p.a. 1.27 1.34 1.34 3.25 3.81 – 0.27 0.29
Aggressive
Net Sharpe ratio 0.72#†† 0.73##†† 0.77##†† 0.52 0.53 – 0.19 0.27
Net MDD (%) 17.98 14.72 11.00 22.23 24.59 – 50.99 40.59
Avrg. turnover p.a. 1.71 1.77 1.87 3.67 4.10 – 0.25 0.29
Notes: This table reports the portfolio performance measures for the full sample from 1993 to 2011 when considering
transaction costs in the optimization function according to Equation (16). The variable transaction costs are set to 30 bp
for all assets. The maximum expected volatility is constrained to 5%, 10%, and 15% p.a. for the conservative, moder-
ate, and aggressive investor type, respectively. */**, # /## , † /†† indicate a significantly higher Sharpe ratio compared to
mean-variance, the strategically weighted benchmark, and the 1/N benchmark at the significance levels of 1% and 5%,
respectively.
includes industry indices for US stocks (US-industries) such as Oil and Gas, Basic Materi-
als, Industrials, Consumer Goods, Health Care, Telecom, Utilities, Financials, Technology, and
Consumer Services for the 1993–2011 period (Datastream indices).
Panel A of Table 12 presents the performance measures (Sharpe ratios) for the two alter-
native multi-asset universes for a moderate investor. The conclusions for the conservative and
aggressive investors are similar. The results confirm the base case in that the BL portfolios are
consistently superior relative to the MV, BS, and naïve approaches. The MV and BS portfolios
also perform slightly better than naïve-diversified portfolios. However, the outperformance of
BS and MV is lower in magnitude and insignificant.
Panel B of Table 12 contains the results for stock-only asset universes.7 Because the risk of
stock-only portfolios is substantially larger than for mixed portfolios, we compute the optimiza-
tion models for the aggressive investor with volatility threshold of 15% p.a. As in our base
case results, the BL model performs consistently better than MV and BS. However, similar
to DeMiguel, Garlappi, and Uppal (2009) and Murtazashvili and Vozlyublennaia (2013), we
find that for stock-only portfolios none of the optimization models is able to outperform naïve-
diversified portfolios such as the 1/N strategy. The likely explanation for this finding is that
in stock-only portfolios the diversification effects and the benefits of reallocating the portfolio
over time are lower and are outweighed by estimation errors (as discussed by Murtazashvili
and Vozlyublennaia 2013) and transaction costs. We conclude that in order to outperform naïve-
diversified portfolios, optimization models require more precise return estimates than provided
Table 12. Alternative asset universes.

Asset Number of BL-Min
universe Period assets s/b/c BL-st.w. BL-1/N Var BS MV st.w. 1/N
Panel A: Multi-asset universes

Base case 1993–2011 2/2/1 0.75∗∗##†† 0.72†† 0.76†† 0.55 0.49 0.32 0.27
Multi-asset USD 1993–2011 8/1/1 0.78** 0.77∗∗## 0.74†† 0.68 0.51 0.43 0.28
Multi-asset EUR 1999–2011 4/2/1 0.83∗∗##†† 0.76†† 0.81##†† 0.46 0.45 0.27 0.18
Panel B: Stock-only universes
Int-stocks 1993–2011 8/0/0 / 0.19 0.15 0.06 0.01 – 0.28
US-industries 1993–2011 10/0/0 / 0.34 0.38 0.23 0.29 – 0.36
Notes: This table reports the portfolio performance (Sharpe ratios) for different asset universes. The column number of
assets shows the number of assets considered in the asset universe, where s is the number of stock indices, b is the number
of bond indices, and c is the number of commodity indices. */**, # /## , † /†† indicate a significantly higher Sharpe ratio
compared to mean-variance, the strategically weighted benchmark, and the 1/N benchmark at the significance levels of
1% and 5%, respectively.
by sample moments. Alternatively, quantitative investors need an asset universe that includes
not only stocks, but also a broader set of assets, providing larger diversification effects and larger
benefits from dynamically reallocating the portfolio, thereby enabling optimization strategies to
provide superior results relative to naïve diversification strategies.
6. Conclusion
We implement a sample-based version of the BL model and analyze its out-of-sample per-
formance relative to BS, MV, minimum-variance, and naïve-diversified portfolios based on
multi-asset rolling sample optimizations for the period from January 1993 to December 2011.
To ensure the comparability of all optimization approaches, we use the same sample moments in
all approaches. Our empirical results contribute to the literature in several dimensions. We find
that the BL model generates a consistently higher out-of-sample performance (Sharpe ratios and
Omega measures) relative to MV, BS, and minimum-variance optimized portfolios. In compar-
ison to naïve diversification strategies with equal or strategic portfolio weights, the BL model
significantly performs better in almost all analyzed cases even after transaction costs.
Furthermore, BL portfolios are less risky as indicated by lower volatility and ‘maximum draw-
down’ (MDD) measures, and are more diversified across asset classes, including a larger number
of assets compared to MV and BS optimized portfolios. Sensitivity analyses suggest that the out-
of-sample outperformance of the BL model compared to MV is due to incorporating additional
information on the reliability of return estimates, resulting in more stable and more accurate
return estimates and consequently in a lower portfolio turnover.
We separate the full sample (1993–2011) into four sub-periods based on the monetary cycle
and stock market signals and find that the BL model outperforms MV and BS in all four sub-
periods, but the outperformance is larger in magnitude during recessionary periods. In line with
the results for the full sample period, we observe the additional benefits of the BL strategy relative
to MV in all sub-periods, such as lower risk (maximum drawdown and volatility), lower portfolio
turnover, and broader portfolio diversification.
The robustness checks confirm that our results are insensitive to restricting optimized portfolio
weights, to short selling restrictions, to all input parameter variations, and to different levels of
transaction costs. This holds even when transaction costs are included in the optimization func-
tion. Finally, our results hold for larger and different sets of assets. For stock-only portfolios,
the BL approaches consistently perform better than MV and BS optimization. However, when
investing solely in stocks, we find that none of the optimization models is able to outperform
consistently naïve-diversified portfolios such as the 1/N strategy. For these stock portfolios, the
diversification effects are lower, and the estimation errors and transaction costs seem to out-
weigh the benefits of reallocating the portfolio over time. Hence, to outperform naïve-diversified
portfolios, optimization models require more precise return estimates than provided by sample
moments or an asset universe that includes not only stocks, but also a broader set of assets
offering larger diversification effects and higher benefits of reallocating the portfolio over time.
Both enable optimization strategies to demonstrate their strengths vis-à-vis naïve diversification
strategies.
Overall, we provide empirical evidence that the BL model consistently performs superior rel-
ative to MV and BS, and significantly outperforms naïve strategies for all analyzed data sets,
sub-periods, and robustness checks. Consequently, quantitative portfolio managers may be able
to improve their asset allocation decisions when employing the BL approach rather than the MV
or BS framework.
Acknowledgements
We are grateful to Chris Adcock (editor) and two anonymous referees for helpful advice and comments that significantly
improved the quality of this research. The authors also thank Lawrence Kryzanowski, Paul Söderlind, Michael Frömmel,
as well as participants at the European Financial Management Symposium 2012, the 19th Annual Meeting of the German
Finance Association 2012, the International Annual Conference of the German OR Society 2012, and the Verein fuer
Socialpolitik Annual Congress 2012 for helpful comments and suggestions.
Notes
1. Value-weighted portfolios weight constituents proportional to their relative market weights and price-weighted
portfolios allocate the fraction of each constituent proportional to its actual market price.
2. Moreover, benchmark portfolios with rebalancing are more common in institutional asset management and we expect
the performance of the portfolios with rebalancing to be less sensitive to the evaluation period compared to the
buy-and-hold portfolio because the portfolio composition of the buy-and-hold portfolio varies over time based on
the relative performance of the assets during the evaluation period.
3. See Opdyke (2007) for a detailed description of the Sharpe ratio test.
4. The results for the other investor types are qualitatively similar so that we only report the performance measures
for the moderate investor. We use the same continuous sample to compute optimized portfolios and divide the
resulting return time series into four sub-samples, thereby avoiding the problems of rolling sample estimations on a
discontinuous sample.
5. It seems surprising that restricting asset weights results in higher Sharpe ratios for conservative investors, but to
an inferior performance for moderate and aggressive investors. The explanation is that the restriction of the asset
weights for the aggressive (moderate) investor results in a maximum portfolio weight of government bonds below
22.5% (50%). Therefore, in periods of stock market downturns, the asset allocation algorithm cannot fully reallocate
the portfolio into the safe asset, thereby loosing performance relative to the unrestricted case.
6. In the BS approach the sample covariance matrix is inflated by the factor (T − 1)/(T − N − 2), where T is the
sample size and N is the number of assets. While for larger observation windows the covariance matrix inflation
in the BS approach plays only a minor role, it gets pronounced for a shorter estimation window of only 12 months
√ factor increases to 2.2 (T = 12; N = 5). In this case, the expected portfolio volatility increases by
as the inflation
the factor 2.2 = 1.48. Because the volatility constraint requires the expected portfolio volatility to be below 10%,
inflating
√ the covariance matrix by a factor of 2.2 is equal to setting the volatility constraint to a level of 6.74%
(10%/ 2.2) instead of 10%.
7. For the stock-only case, we do not compute strategically weighted portfolios as strategic weights are only used to
determine the fraction of stocks relative to bonds and commodities and we do not have any reason to set different
strategic weights for different industries or countries on an ex ante basis.
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This article was downloaded by: [FU Berlin]

On: 15 May 2015, At: 01:39

The European Journal of Finance

Multi-asset portfolio optimization and out-

To link to this article: http://dx.doi.org/10.1080/1351847X.2014.953699

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Multi-asset portfolio optimization and out-of-sample performance: an evaluation

Wolfgang Besslera∗ , Heiko Opferb and Dominik Wolffa

(Received 16 November 2012; final version received 7 August 2014)

Keywords: portfolio optimization; Black–Litterman; mean-variance; minimum-variance; Bayes–Stein;

JEL Classification: C61; G11

∗ Corresponding author. Email: wolfgang.bessler@wirtschaft.uni-giessen.de

Table 1. Overview of asset allocation models included.

Number Model Abbreviation

Naïve asset allocation rules

the various strategies is compared.

2.1 Naïve diversification rules

Table 2. Strategically weighted portfolios.

Benchmark portfolio weights Optimization

Conservative 80 15 5 4.58 5.00

2.2 Minimum-variance portfolio

ˆ using rolling estima-

2.3 Mean-variance (MV) optimized portfolio

2.4 Bayes–Stein shrinkage portfolio

2.5 Black–Litterman portfolio

μ̂BL = [(τ )−1 + P −1 P]−1 [(τ )−1

Figure 1. The procedure of the Black–Litterman approach (Idzorek 2005).

2.5.1 Implied returns and the parameter τ

2.5.2 ‘Subjective’ return estimates and their reliability

2.6 Performance measures

Table 3. Descriptive statistics of asset returns (January 1993–December 2011).

US High Yield S&P GSCI

Mean return p.a. (%) 6.71 8.00 6.16 7.31 2.66

Table 4. Correlation matrix of asset classes (January 1993–December 2011).

US High Yield S&P GSCI

Investor type: conservative

4.2 Performance of optimized portfolios in different market environments

Figure 2. BL and MV optimized portfolio weights (base case).

Figure 3. Definition of sub-periods.

Table 6. Analysis of sub-periods.

BL-st.w. BL-1/N BL-MinVar BS MV MinVar st.w. 1/N

January 1993–January 2001

5.1 Alternative optimization constraints

5.1.1 Restrictions on optimized portfolio weights

5.1.2 Short selling constraint

5.1.3 Volatility constraint

5.1.4 Variations of the risk aversion parameter

Table 7. Restriction of optimized portfolio weights.

BL-st.w. BL-1/N BL-MinVar BS MV MinVar st.w. 1/N

5.2 Alternative estimation windows

Panel A: Variation of optimization constraint: maximum allowed portfolio volatility

Panel B: Variation of risk aversion coefficient

Delta BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV BL-st.w. BS MV st.w. 1/N

The European Journal of Finance

Panel C: Variation of estimation window for covariance matrix

Panel D: Variation of estimation window for historic return estimates

5.3 Varying BL model parameters τ and 

5.4 The impact of transaction costs

Parameter τ n/a (τ → ∞) 1 0.3 0.15 0.1 0.05 0.025 (τ → 0)

BS MV BL-st.w varying estimation window for  st.w

BS MV BL-st.w varying overall confidence level c for views st.w

Parameter c n/a (τ → ∞) 0.1 2 5 10 20 100 (τ → 0)

Table 10. The influence of transaction costs.

5 0.85##†† 0.82##†† 0.87##†† 0.64 0.61 0.32 0.27 0.76##††

μ̂BL = [(τ )−1 + P −1 P]−1 [(τ )−1

5.3 Varying BL model parameters τ and

BS MV BL-st.w varying estimation window for st.w