The Black-Litterman Model:

Extensions and Asset Allocation1

Omer CAYIRLI2

1
This working paper was written as a part of author’s studies in PhD in Finance at University of South Florida
Business School.
2
Former Assistant Specialist at Central Bank of Republic of Turkey, Markets Department, Foreign Exchange
Transactions Division, University of North Carolina-Chapel Hill Kenan-Flagler MBA 2007

Electronic copy available at: https://ssrn.com/abstract=3464770

 INTRODUCTION

The Black-Litterman Model (BLM), created by Fischer Black and Robert Litterman, is a

sophisticated portfolio construction method that overcomes the problem of unintuitive, highly-

concentrated portfolios, input-sensitivity, and estimation error maximization. The BLM uses a

Bayesian approach to combine the subjective views of an investor regarding the expected

returns of one or more assets with the market equilibrium vector of expected returns (the prior

distribution) to form a new, mixed estimate of expected returns. The resulting new vector of

returns (the posterior distribution), leads to intuitive portfolios with sensible portfolio weights.

(Idzorek, 2004).

BLM was first introduced in Black and Litterman (1990) and further explained in Black

and Litterman (1991) and Black and Litterman (1992) It is an asset allocation model which has

its roots in mean-variance (MV) optimization model and capital asset pricing model (CAPM).

Model builds on MV optimization and CAPM by using a Bayesian framework that allows

investors to incorporate their views on markets effectively into asset allocation process.

Main contribution of BLM is that it enables investors to construct sensible portfolios

without using unnecessary constraints which also reflect their views on markets. It is well known

to both academics and practitioners that standard MV optimization is very sensitive to expected

returns and often generates extreme portfolios (concentration in very few assets, large long and

short positions). BLM overcomes these issues by choosing a neutral reference point, CAPM

equilibrium. It also allows investors to express their views with varying confidence levels and

integrate these views into CAPM prior by using a Bayesian framework.

As a result, since its introduction BLM has been increasingly used among practitioners

and allowed asset allocation decisions to be in more of a quantitative nature rather than

qualitative because of the apparent shortcomings of MV optimization model.

Electronic copy available at: https://ssrn.com/abstract=3464770

BLACK-LITTERMAN MODEL (BLM)

Foundations of BLM

Black and Litterman (1991) explains the intuition behind BLM as follows:

• There are two distinct sources of information about future excess returns:

investor views and market equilibrium.

• Both sources of information are uncertain and are best expressed as probability

distributions.

• Hence, choose expected excess returns that are as consistent as possible with

both sources of information.

In standard MV optimization, the user inputs a complete set of expected returns and the

portfolio optimizer generates the optimal portfolio weights. Because there is a complex mapping

between expected returns and the portfolio weights, and because there is no natural starting

point for the expected return assumptions, users of the standard portfolio optimizers often find

their specification of expected returns produces output portfolio weights which do not seem to

make sense. In the BLM the user inputs any number of views, which are statements about the

expected returns of arbitrary portfolios, and the model combines the views with equilibrium,

producing both the set of expected returns of assets as well as the optimal portfolio weights (He

and Litterman, 1999).

BLM is an equilibrium approach to asset allocation since its starting point is market

portfolio and CAPM equilibrium. As Black and Litterman (1991) puts forth, a neutral reference is

a critically important input in making use of MV optimization model, and equilibrium provides the

appropriate neutral reference. Purpose of the equilibrium is to give investor an appropriate point

of reference so that he can express his views in a realistic manner.

Electronic copy available at: https://ssrn.com/abstract=3464770

 BLM does not assume that the world is always at the CAPM equilibrium, but rather that

when expected returns move away from their equilibrium values, imbalances in markets tend to

push them back (Black and Litterman, 1991).

Model3

Assume there are N assets in the market and returns of these assets (r) are normally

distributed with expected return (μ) and a known constant covariance matrix (Σ), r ∼ N(μ, Σ)

Assuming the average risk tolerance of the world is represented by the risk aversion

parameter δ, the equilibrium risk premiums (Π) are given by

Π = δΣweq , (1)

where weq represents the weights of assets in the market portfolio.

The Bayesian prior is that the expected returns (μ) are normally distributed with the

mean of Π,

μ = Π+ϵ(e) , (2)

where ϵ(e) is a normally distributed random vector with zero mean and covariance matrix τΣ,

ϵ(e) ∼ N(0, τΣ) . (τ is a scalar indicating the uncertainty of CAPM and we provide more

information on later sections) As a result, BLM expected excess returns are random variables

centered around equilibrium excess returns.

These results are obtained by solving the following unconstrained maximization problem,

𝛿
max 𝑤 ′ 𝛱 − 2
𝑤 ′Σ w (3)
𝑤

As long as μ = Π, w will be equal to the market weights, weq.

In addition to CAPM prior, the investor also has a number of views on the market

returns. A view is expressed as a statement that the expected return of a portfolio p has a

normal distribution with mean equal to q and a standard deviation given by ω, p(r)~N(q,𝜔2 ). Let

3
Model presented in this section is mostly based on the one presented in (He and Litterman, 1999)

Electronic copy available at: https://ssrn.com/abstract=3464770

K be the total number of views, P be a KxN matrix whose rows are portfolio weights and Q be a

K-vector of the expected returns on these portfolios.

𝑃′ =(p1 , p2 ,…, pK ) (4)

Q' =(q 1 , q 2 ,…, qK ) (5)

In this setting investor’s views can be expressed as

𝑃𝜇=Q + ϵ(v) (6)

where ϵ(v) is an unobservable normally distributed random vector with zero mean and a

diagonal covariance matrix Ω, ϵ(v) ∼ N(0, Ω).

It is also assumed that ϵ(e) and ϵ(v) are independent.

̅ −1 ), where the mean 𝜇̅ is

The result is that the expected returns are distributed as 𝑁 (𝜇̅ , 𝑀

given by

μ̅ =[ (τΣ)-1 +P ' ΩP ]-1 [ (τΣ)-1 Π+P ' Ω-1 Q ] (7)

̅ −1 is given by
and the covariance matrix 𝑀

̅ −1 =[ (τΣ)-1 +P ' Ω-1 P ]-1

𝑀 (8)

̅ −1
𝛴̅ = 𝛴 + 𝑀 (9)

Risk Aversion Coefficient (δ)

According to (Black and Litterman, 1991), the risk-aversion coefficient (δ) is a

proportionality constant based on (F. Black, 1989).

Usual definition of δ is market risk premium divided by market variance as pointed out in

(Idzorek, 2004) and (Satchell and Scowcroft, 2000).

δ characterizes the expected risk-return tradeoff. It is the rate at which an investor will

forego expected return for less variance. In the reverse optimization process, the risk aversion

coefficient acts as a scaling factor for the reverse optimization estimate of excess returns; the

weighted reverse optimized excess returns equal the specified market risk premium (Idzorek,

Electronic copy available at: https://ssrn.com/abstract=3464770

2004). He and Litterman (1999) take δ as a global risk aversion coefficient and assign a value of

2.5 for their applications.

̂ ∗ can be obtained by
For an investor with a different risk tolerance, the optimal portfolio 𝑤

scaling the portfolio 𝑤 ∗

̂ ∗ = (𝛿/𝛿̂ )𝑤 ∗
𝑤 (10)

where 𝛿̂ is the risk aversion parameter for the investor (He and Litterman, 1999).

Exhibit 1: Deriving the New Combined Return Vector

Electronic copy available at: https://ssrn.com/abstract=3464770

 View Portfolios

In BLM, views represent the subjective feelings of the investor about relative values

offered in different markets. An investor is not required to state a view about a given market

unless he has a view. In addition, if some of views are more strongly held than others investor is

able to express the differences (Black and Litterman, 1992). This is one of the major

improvements to MV approach since MV requires investors to provide expected returns for

assets or asset classes included in the investment universe, which is a daunting task. Moreover

in MV there is no efficient way of incorporating relative views whereas BLM efficiently generates

posterior expected returns based prior returns, views, view uncertainty and covariance matrix.

BLM not only updates the expected returns of assets that investor has a view but all assets

based on the covariance structure.

BLM allows investors to use absolute views as well as relative views. In Exhibit 2 first

view portfolio (p1) represents an absolute view on Asset 2. Second view portfolio (p2)

represents a relative view in which Asset 4 overperforms Asset 1. Last view portfolio (p3)

represents a relative view in which a market cap-weighted portfolio of Asset 2 and Asset 3

outperforms Asset 5.

Exhibit 2: Representation of absolute and relative view portfolios

Column1 Asset 1 Asset 2 Asset 3 Asset 4 Asset 5
p1 0 1 0 0 0
p2 -1 0 0 1 0
p3 0 0.4 0.6 0 -1

In Exhibit 3, q1 represents the expected return on p1. Since p1 is an absolute view q1 is

basically the expected excess return of Asset 1. q2 represents the expected return on p2, and

q3 represents the expected return on view portfolio p3.

Exhibit 3: Representation of absolute and relative views

q1 2.00%
q2 0.50%
q3 1.00%

Electronic copy available at: https://ssrn.com/abstract=3464770

 Whether it is absolute or relative view, a view’s effect on the asset allocation depends on

how it differs from the equilibrium. To state more clearly, for an absolute view as represented by

in p1 above, if the expected return is greater than the equilibrium return than the asset under

consideration will have higher allocation and vice versa. For a relative view, ending portfolio

weights will depend on the difference between view expected returns and equilibrium expected

returns. If views point a higher relative expected return compared with relative equilibrium

expected returns, resulting portfolio will suggest holding higher shares of assets which are

favored in the view portfolio.

Uncertainty in Views (Ω)

Ω is the covariance matrix of unobservable normally distributed random vector of error

terms, ε(v), from expressed views. In Black and Litterman (1992) and He and Litterman (1999) it

is assumed that Ω is diagonal. A diagonal Ω corresponds to the assumption that the views

represent independent draws from future distribution of returns, or that the deviations of

expected returns from the means of the distribution representing each view are independent

(Black and Litterman, 1992)

Diagonal elements of Ω are ω1, ω2, …, ωk where ωk represents the confidence level of

kth view. Normally diagonal elements of Ω are different than zero. However, as mentioned in

Walters (2009) they can be zero if investor is 100% confident in his view.

𝜔1 0 0
Ω= [0 ⋱ 0]
0 0 𝜔𝑛

He and Litterman (1999) sets ωk/ 𝜏 to be equal to individual variances of view portfolios

which is (p1Σ p1’). Then,

(𝑝1 𝛴𝑝1′ ) ∗ 𝜏 0 0
Ω= [ 0 ⋱ 0 ]
0 0 (𝑝𝑛 𝛴𝑝𝑛′ ) ∗ 𝜏

Electronic copy available at: https://ssrn.com/abstract=3464770

 As Idzorek (2004) points out in this setting, changes in scalar 𝜏 effects the diagonal

elements of Ω, but combined return vector is not affected by these changes.

Scalar for Uncertainty of CAPM Prior (τ)

𝜏 is a measure of the investor’s confidence in the prior estimates (Walters 2010). Black

and Litterman (1992) argues that since the uncertainty in the mean is much smaller than the

uncertainty return itself, τ will be close to zero. He and Litterman (1999) assumes 𝜏 to be 0.05,

corresponding to the confidence level of the CAPM prior mean if it was estimated using 20

years of data. Satchell and Scowcroft (2000) sets 𝜏 to 1 with assumption that the equilibrium

excess returns conditional upon the individual’s forecasts equals the individual forecast on

average. Meucci (2010) argues that in practice, a tailor-made calibration that spans the interval

(0, 1) is called for most applications.

Walters (2010) considers three methods to select a value for 𝜏: Estimating 𝜏 from the

standard error of the equilibrium covariance matrix, using confidence intervals, and examining

the investor’s uncertainty as expressed in their prior portfolio.

Exhibit 4: Indices, Market-Capitilizations and Implied Equilibrium Returns

Market Capitalization Market Equilibrium
(Billion USD) Weight Excess Returns
G0BA US Treasury Bills 1768.93 3.59% 0.00%
G0Q0 US Treasury Master 6456.63 13.10% 0.37%
G0P0 AAA US Agcy Master 2728.09 5.54% 0.28%
M0A0 Mortgage Master 8911.52 18.09% 0.21%
C0A0 US Corp Master 7535.90 15.29% 0.44%
EGB0 Euro Govt Bill 937.42 1.90% 0.00%
EG00 EMU Direct Govt 6923.78 14.05% 0.25%
ER00 EMU Corp 4591.86 9.32% 0.23%
UK00 Sterling Broad Mkt 1706.80 3.46% 0.31%
G0Y0 Japanese Govts 7712.16 15.65% 0.08%

BLM APPLICATION

In this section I provide an application of BLM. Application is carried on data that

includes monthly hedged USD returns of 10 broad Bank of America Merrill Lynch bond indices

Electronic copy available at: https://ssrn.com/abstract=3464770

as asset classes between January 1998 and December 2010. Covariances are calculated over

monthly excess returns which is basically the monthly return minus risk-free rate. Risk-free rate

is obtained from Kenneth R. French’s data library. Market capitalizations are obtained from

SIFMA (US), US Treasury, Office for National Statistics (UK), European Central Bank, and

Ministry of Finance (Japan). Market capitalizations are converted to USD using representative

exchange rates published by International Monetary Fund for end of 2010.

Exhibit 5 displays the optimal risky portfolios based on standard MV optimization and

BLM without views. It is apparent that MV optimization produces portfolios that are not plausible

in practice. Without short-sale constraint MV results imply a huge long position in EGB0 and

short positions in US Treasury Bill and US Agencies. Adding a short sale constraint does not

help much as we now have a huge long position in EGB0 accompanied with small positions in

US mortgages and Euro corporates. In both cases, deviations from the market portfolio are

significant.

Exhibit 5: Optimal Portfolios

Divergence from Market
Optimal Portfolios Portfolio
Market
MV_1* MV_2** BL*** Weights MV_1 MV_2 BL
G0BA -39.86% 0.00% 3.59% 3.59% -43.45% -3.59% 0.00%
G0Q0 1.76% 0.00% 13.10% 13.10% -11.34% -13.10% 0.00%
G0P0 -16.04% 0.00% 5.54% 5.54% -21.58% -5.54% 0.00%
M0A0 21.60% 4.44% 18.09% 18.09% 3.51% -13.64% 0.00%
C0A0 0.30% 0.13% 15.29% 15.29% -14.99% -15.16% 0.00%
EGB0 128.90% 91.02% 1.90% 1.90% 127.00% 89.12% 0.00%
EG00 -8.05% 0.00% 14.05% 14.05% -22.11% -14.05% 0.00%
ER00 8.42% 4.41% 9.32% 9.32% -0.90% -4.91% 0.00%
UK00 1.47% 0.00% 3.46% 3.46% -1.99% -3.46% 0.00%
G0Y0 1.49% 0.00% 15.65% 15.65% -14.16% -15.65% 0.00%

* MV_1 is based on historical returns and optimized without short-sale constraint.

** MV_2 is based on historical returns and optimized with short-sale constraint.
*** BL portfolio is based on BL returns and optimized without short-sale constraints.

Electronic copy available at: https://ssrn.com/abstract=3464770

 Now assume that investor has two views: US corporates will outperform US mortgage-

backed securities by 10 basis points and US Treasury notes and bonds will outperform EMU

direct government bonds by 10 basis points. These view portfolios can be represented as

follows:

Exhibit 6: Investor’s View Portfolios

G0BA G0Q0 G0P0 M0A0 C0A0 EGB0 EG00 ER00 UK00 G0Y0
P1 0 0 0 -1 1 0 0 0 0 0
P2 0 1 0 0 0 0 -1 0 0 0

1
Given these views and setting 𝜏 = 12 we calculate the BLM combined view returns

(posterior returns) and run standard MV optimizations to obtain the optimal risky portfolio 1

(without short-sale constraint) and optimal risky portfolio 2 (with short-sale constraint). Results

are presented in Exhibit 7. First observation is that for unconstrained optimization, only weights

of assets that investor has view(s) change. Another observation is that even if the investor’s

view is that C0A0 outperforming M0A0 by 10 basis points, in the resulting portfolio M0A0 has

increased weight and C0A0’s weight decreases. Optimal portfolio tilts towards M0A0 because

investor’s view implies that excess return spread between M0A0 and C0A0 will decrease from

23 basis points to 17 basis points given the covariance structure and implied equilibrium returns.

We should also note that excess return spread is still higher than the view. This is because of

the uncertainty in views. More uncertainty in views will cause combined view vector to be closer

to BLM equilibrium returns.

Asset Allocation and BLM Implied Views

Once an investor has established his objectives, an asset allocation model establishes a

correspondence between views and optimal portfolios. It is often useful to start an analysis by

using a model to find the implied investor views for which an existing portfolio is optimal. The

weights relative to benchmark or market portfolio define the directions of the investor’s views.

By assuming the investor’s degree of risk aversion one can find the excess returns for which the

portfolio is optimal (Black and Litterman, 1992).

10

Electronic copy available at: https://ssrn.com/abstract=3464770

 Exhibit 7: Investor’s View Portfolios
Divergence
Optimal Optimal Optimal
Equilibrium Combined Optimal
Market Risky Risky Risky
Excess View Risky
Weight Portfolio Portfolio Portfolio
Returns Returns Portfolio 1
1 2 2
G0BA 3.59% 0.00% 0.00% 3.57% 2.70% -0.02% -0.89%
G0Q0 13.10% 0.37% 0.35% 12.88% 12.94% -0.22% -0.16%
G0P0 5.54% 0.29% 0.27% 5.54% 5.63% 0.00% 0.10%
M0A0 18.09% 0.21% 0.20% 26.59% 26.78% 8.50% 8.69%
C0A0 15.29% 0.44% 0.37% 6.80% 6.84% -8.49% -8.45%
EGB0 1.90% 0.00% 0.01% 1.91% 2.09% 0.00% 0.19%
EG00 14.05% 0.25% 0.24% 14.28% 14.39% 0.23% 0.34%
ER00 9.32% 0.23% 0.19% 9.33% 9.38% 0.01% 0.06%
UK00 3.46% 0.32% 0.29% 3.46% 3.48% 0.00% 0.02%
G0Y0 15.65% 0.08% 0.08% 15.65% 15.76% 0.00% 0.11%

Implied views are particularly important in terms of strategic asset allocation. In strategic

asset allocation process it is not unusual for some asset classes to be left out of the portfolio or

to be assigned less weights compared to market weights despite being in investment universe.

BLM implied returns provide a solid method for assesing optimality of these decisions. It is

interesting that neither academicians nor practicians paid little attention to this aspect of BLM in

assesing the optimality of portfolios.

Equations (8) and (9) determine the posterior covariance matrix when investor has

view(s).

μ̅ =[ (τΣ)-1 +P ' ΩP ]-1 [ (τΣ)-1 Π+P ' Ω-1 Q ] (7)

̅ −1 =[ (τΣ)-1 +P ' Ω-1 P ]-1

𝑀 (8)

̅ −1
𝛴̅ = 𝛴 + 𝑀 (9)

Solving equation (7) for implied views (Q) using equation (8), yields to equation (11):

̅ 𝜇̅ − (𝜏𝛴)−1 𝛱]
𝑄 = [(𝑃′ 𝛺 −1 )′ (𝑃′ 𝛺 −1 )]−1 (𝑃′ 𝛺 −1 )′ [𝑀 (11)

11

Electronic copy available at: https://ssrn.com/abstract=3464770

 Equation (11) basically states that for a given asset allocation one can calculate the

implied views of an investor using known prior covariance matrix, posterior covariance matrix, 𝜏,

and view portfolio variances.

Assume an investor decides to allocate his neutral portfolio assets in M0A0 and G0P0 to

G0Q0 without stating any views, just the desired portfolio allocations. Still we can form a view

portfolio based on this information:

Exhibit 8: Implied View Portfolio

G0BA G0Q0 G0P0 M0A0 C0A0 EGB0 EG00 ER00 UK00 G0Y0
P1 0.00 1.00 -0.23 -0.77 0.00 0.00 0.00 0.00 0.00 0.00

P1 implies that investor’s view portfolio consists of short position in a market-cap

weighted portfolio of G0P0 and M0A0 and long position in G0Q0. Combined view returns based

on this information are presented in the following exhibit. Implied view for our investor is

0.239%, which means that he expects G0Q0 to outperform market-cap weighted portfolio of

G0P0 and M0A0 by 24 basis points. Only after checking this implied view and assesing its

plausibility investor should decide on the final asset allocation.

Exhibit 9: Portfolio Allocation and Combined View Returns

Change Equilibrium Combined
Market Portfolio
in Excess View
Weight Allocation
Weights Returns Returns
G0BA 3.59% 3.59% 0.00% 0.00% 0.00%
G0Q0 13.10% 36.73% 23.62% 0.37% 0.47%
G0P0 5.54% 0.00% -5.54% 0.29% 0.35%
M0A0 18.09% 0.00% -18.09% 0.21% 0.25%
C0A0 15.29% 15.29% 0.00% 0.44% 0.51%
EGB0 1.90% 1.90% -0.01% 0.00% 0.01%
EG00 14.05% 14.05% 0.00% 0.25% 0.31%
ER00 9.32% 9.32% 0.00% 0.23% 0.26%
UK00 3.46% 3.46% 0.00% 0.32% 0.39%
G0Y0 15.65% 15.65% 0.00% 0.08% 0.10%

12

Electronic copy available at: https://ssrn.com/abstract=3464770

BLM EXTENSIONS

Incorporating User-Specified Confidence Levels (Idzorek, 2004)

In BLM, usual approach to confidence level of the views is using the variance of the view

portfolio and scaling it by using 𝜏. Idzorek (2004) argues that there may be other sources of

information in addition to the variance of the view portfolio that affect an investor’s confidence in

a view and these factors should be combined with the variance of the view portfolio to produce

the best possible estimates of the confidence levels in the views.

Idzorek (2004) starts with finding the implied confidence levels in views. His approach in

finding implied confidence levels is solving for BLM combined view vector for 100% confidence

level for a view portfolio as well as variance of the view portfolio. He then calculates the

deviations from market portfolio based on these two approaches and defines the implied

confidence level as follows:

̂ −𝑤𝑒𝑞
𝑤
𝐼𝑚𝑝𝑙𝑖𝑒𝑑 𝐶𝑜𝑛𝑓𝑖𝑑𝑒𝑛𝑐𝑒 𝐿𝑒𝑣𝑒𝑙 = 𝑤̂
100% −𝑤𝑒𝑞

̂ is weight vector based on the covariance matrix of the error term (Ω), and 𝑤
where 𝑤 ̂100%is

weight vector based on 100% confidence.

He, then, proposes the diagonal elements of Ω be derived in a manner that is based on

the user-specified confidence levels and that results in portfolio tilts of,

𝑇𝑖𝑙𝑡𝑘 = (𝑤100% − 𝑤𝑒𝑞 ) ∗ 𝐶𝑘

where 𝑇𝑖𝑙𝑡𝑘 is the approximate tilt caused by the kth view, and 𝐶𝑘 is the confidence in the kth

view. In this setting, in the absence of other views, the approximate recommended weight vector

is:

𝑤𝑘,% ≈ 𝑤𝑒𝑞 + 𝑇𝑖𝑙𝑡𝑘

where 𝑤𝑘,% is the target weight vector based on the tilt caused by the kth view.

Idzorek (2004)’s procedure for determining Ω and combined view vector based on user-

specified confidence levels is as follows: Calculate combined view vector for each view under

13

Electronic copy available at: https://ssrn.com/abstract=3464770

100% certainty, calculate 𝑤𝑘,100% using the unconstrained maximization formula, calculate the

maximum departures from the market capitalization weights caused by 100% confidence in the

kth view by using 𝐷𝑘,100% = (𝑤𝑘,100% − 𝑤𝑒𝑞 ) where 𝐷𝑘,100% is the departure from the market

capitalization weight based on 100% confidence in kth view, multiply the N elements of 𝐷𝑘,100%

by the user- specified confidence in the kth view to estimate the desired tilt caused by the k th

view (𝑇𝑖𝑙𝑡𝑘 = 𝐷𝑘,100% ∗ 𝐶𝑘 ), estimate the target weight vector based on the tilt (𝑤𝑘,% = 𝑤𝑒𝑞 +

𝑇𝑖𝑙𝑡𝑘 ), find the value of ωk, that minimizes the sum of the squared differences between wk,% and

wk subject to the constraint ωk>0, and finally repeat all previous steps for K views to build a KxK

diagonal Ω matrix and solve for the combined return vector.

Representing the uncertainty of views and specifying the diagonal elements of Ω in BLM

is not straightforward and not intuitive as the model itself. However, Idzorek (2004)’s method

provides a tool that can be used to estimate Ω from the confidence levels provided by investors

instead of relying on variance of view portfolios and𝜏.

Qualitative Forecasts (Herold, 2003)

Portfolio construction method presented in (Herold, 2003) has two basic aspects: A

Bayesian model similar to BLM which is used for refining alphas, and diagnostic tools for

analyzing the views and a given portfolio. In this approach views are not about a single asset or

asset class since model is aimed at active risk-return space. Instead of taking the market

portfolio as the starting point, neutral reference is benchmark portfolio and incorporates

qualitative views of investors in a framework that maximizes the following alpha/tracking error

objective function:

𝜆𝐴 2 ′ 𝜆𝐴 ′
max (𝛼𝑝 − 𝜓𝑃 ) = max (ℎ𝑃𝐴 𝛼𝐵𝑎𝑦𝑒𝑠 − ℎ 𝛴ℎ𝑃𝐴 )
ℎ𝑃𝐴 2 ℎ𝑃𝐴 2 𝑃𝐴

where hPA denotes vector of active portfolio weights, λA is the investor’s aversion to active risk,

and ψP denotes tracking error.

14

Electronic copy available at: https://ssrn.com/abstract=3464770

 Alpha (α) is defined as expected residual return and prior distribution of alpha is given by

α ~ N(0, 𝜏𝛴). Managers will diverge from the benchmark portfolio if they expect alphas to be

different from zero and the levels of conviction a manager has in those views determine the

extent of this deviation. In this context views are summarized by Pα ~ N(q, 𝛺).Views are stated

as a long/short portfolio as it is the case for relative BLM views and tracking error variances of

view portfolios form the on-diagonal elements of 𝛺 = 𝑑𝑖𝑎𝑔(𝑃𝛴𝑃′ ).

The prior distributions of the alphas and the views are combined to obtain the posterior

distribution of alphas which is,

𝛼𝐵𝑎𝑦𝑒𝑠 = [𝛴 −1 + 𝑃′ 𝛺−1 𝑃]−1 [𝑃′ 𝛺−1 𝑞]

(Herold, 2003) uses view correlation matrix, view risk contributions, and view implied

alphas and information ratio shrinkage as diagnostic tools.

View correlation matrix serves the purpose that views are consistent with each other

according to the risk model. View correlations are extracted from the covariance matrix of the

views.

View risk contributions are used to analyze how much each view contributes to total

tracking error for a given portfolio. Marginal contributions to tracking error (MCTE) on a view

level obtained by differentiating the following equation that defines the tracking error with

respect to hPA,
′
𝜓𝑃 = ( ℎ𝑃𝐴 𝛴ℎ𝑃𝐴 )0.5

Implied alphas are obtained by reverse optimization and they are proportional to the

MCTEs. The implied alpha for asset i (i=1, …, N) and implied alpha for view j (j=1, …, K) are

given by,
𝑖𝑚𝑝𝑙𝑖𝑒𝑑 𝑖𝑚𝑝𝑙𝑖𝑒𝑑
𝛼𝑖 = 𝜆𝐴 𝑀𝐶𝑇𝐸𝑖 𝜓𝑃 and 𝛼𝑗 = 𝜆𝐴 𝑀𝐶𝑇𝐸𝑗 𝜓𝑃 .

Implied alphas, along with the risk contributions, allow a judgment as to whether the risk

profile of the portfolio is accordance with the conviction that managers have in their views.

15

Electronic copy available at: https://ssrn.com/abstract=3464770

 Lastly, information ratio (IR) is defined as alpha divided by tracking error and is

calculated based on the refined alphas,

′
ℎ𝑃𝐴 𝛼𝐵𝑎𝑦𝑒𝑠
𝐼𝑅𝐵𝑎𝑦𝑒𝑠 = 𝜓𝑃
.

By determining the shrinkage in information ratio, it is possible to assess how far the

actual portfolio is from an optimized solution.

Two-Factor Black-Litterman Model (Krishnan and Norman 2005)

In BLM and the underlying CAPM it is assumed that risk can be completely

characterized by covariance. Krishnan and Norman (2005) focuses on this assumption and

argues that the expected return of an asset class should increase with its volatility and its beta

to alternative risk factors based on the vast research on multifactor models. Following Cochrane

(1999), Krishnan and Norman (2005) defines alternative risk factors as recession risk and

incorporates the recession risk into the BLM using the performance of distressed bonds as a

proxy. The BLM assumes that investors make allocation decision relative to the utility function

𝛿
𝑈(𝑤, 𝑟) = 𝑤 ′ 𝑟 − ( ) 𝑤 ′ 𝛴𝑤 which is the same as the quadratic utility function used in standard
2

MV optimization.

Krishnan and Norman (2005) assumes that views are specified with 100% confidence.

Hence, instead of the usual BLM combined return vector formula they use the following:

𝜇̅ = 𝛱 + 𝛴𝑃′ (𝑃𝛴𝑃′ )−1 (𝑄 − 𝑃𝛱)

This is similar to the formula Idzorek (2004) uses when computing the implied

confidence levels in views.

To incorporate the recession risk into the BLM, Krishnan and Norman (2005) prefers to

use the following utility function:

16

Electronic copy available at: https://ssrn.com/abstract=3464770

 𝛿
𝑈(𝑤, 𝑟) = 𝑤 ′ 𝑟 − ( ) 𝑤 ′ 𝛴𝑤 − 𝛾𝑤 ′ 𝛽
2

where β is a vector measuring the sensitivity of each asset class to a recession factor. In this

setting it follows that the multi-factor equilibrium formula is given by,

𝛱∗ = 𝛿𝛴𝑤 + 𝛾𝑗 𝛽 𝑗

where 𝛽 𝑗 is a vector containing the beta of each asset class to the factor 𝑓 𝑗 . 𝛾𝑗 is a risk aversion

parameter that is defined as follows assuming that over the long term an investor collects 𝑟𝑗 for

taking factor risk 𝑓 𝑗 ,

𝑟𝑗 −𝛾𝑤𝑗′ 𝛴𝑤
𝛾𝑗 ≈ 𝑤𝑗′ 𝛽 𝑗
,

where 𝑤𝑗 are simply the coefficients of a linear regression and define the closest combination of

asset class to the returns of a given factor.

Using a market-neutral version of the NYU Altman Defaulted Public Bond index as a

proxy for recession risk, Krishnan and Norman (2005) finds that the two-factor BLM allocates

more conservatively to asset classes that have a positive alternative beta, as expected.

Stable Distributions and BLM (Giacometti, et al. 2007)

Giacometti et al. (2007) has its motivation from the fact that the computation of both the

equilibrium portfolio and the posterior distribution rely on the assumption of a normal market and

investigate whether BLM can be enhanced by using stable Paretian distributions as a statistical

tool for asset returns. They generalize the procedure of the BLM allowing introduction of

dispersion matrices obtained from multivariate Gaussian distribution, symmetric t-Student and

α-stable distributions for computing the equilibrium returns.

Giacometti et al. (2007) considers different problems of optimal allocation among risky

assets using variance, value at risk (VaR), and conditional value at risk (CVaR) as risk

measures. In this context, they solve the following maximization problem:

17

Electronic copy available at: https://ssrn.com/abstract=3464770

 𝛿
max 𝑤 ′ 𝛱 − 𝜌(𝑟 ′ 𝑤)
𝑤 2

assuming that all portfolios (𝑟 ′ 𝑤) are uniquely determined by the neutral mean 𝑤 ′ 𝛱 and the risk

measure ρ( ) that is defined alternatively as the dispersion 𝑤 ′ 𝑉𝑤, the Varφ (𝑟 ′ 𝑤), and the

CVarφ (𝑟 ′ 𝑤) where V is a dispersion matrix and 𝜑 is the percentile of probability density function.

Applying the reverse optimization model, and using the three different measures of risk

along with Gaussian, t-student and stable distributions, Giacometti et al. (2007) obtain the

following equilibrium returns equations:

Variance: 𝛱 = 𝛿𝑉𝑤

𝛿 𝑉𝑤
CVar : 𝛱 = (𝐶𝑉𝑎𝑅𝜑 − 𝐸(𝑟))
2 √𝑤 ′ 𝑉𝑤

𝛿 𝑉𝑤
VaR : 𝛱 = (𝑉𝑎𝑅𝜑 − 𝐸(𝑟))
2 √𝑤 ′ 𝑉𝑤

where 𝐸(𝑟)~𝑁(𝛱, 𝜏𝛴).

Giacometti et al. (2007) provides a tool for using realistic models for asset returns and

enables investors to avoid the problems with the underlying normality assumption. In addition to

introducing α-stable distributions to BLM tool set; it also derives equilibrium excess returns for

dispersion-based risk measures, VaR and CVaR. However, we should note that although VaR

is used widely in practice it is not a coherent risk measure like CVaR since VaR doesn’t have

the subadditivity property [ρ(X + Y) ≤ ρ (X) + ρ(Y )], hence not convex (Artzner et al., 1999).

CONCLUSION

Markowitz’s MV optimization model revolutionized the approach to asset allocation

decisions. However, inherent problems with MV optimization hindered the efforts to make

quantitatively oriented asset allocation decisions. In practice, asset allocation decisions either

completely ignored MV optimization context or used it with very specific constraints. One of the

18

Electronic copy available at: https://ssrn.com/abstract=3464770

main contributions of BLM is enabling the investor’s to construct sensible portfolios without

using unncessary constraints.

BLM also overcame most of the problems investors faced with MV optimization by

simply adding a neutral reference point (CAPM equilibrium) for expected returns. It also

provided the investors the ability incorporate their views effectively in the asset allocation

process.

As a result, BLM has received broad acceptance within the investment community and

became one of the building blocks of modern portfolio theory.

19

Electronic copy available at: https://ssrn.com/abstract=3464770

References

Black, Fischer, and Robert Litterman. "Asset Allocation: Combining Investor Views with Market
Equilibrium." Goldman, Sachs & Co., 1990.

Black, Fischer, and Robert Litterman. "Global Asset Allocation with Equities, Bonds, and Currencies."
Goldman, Sachs & Company Fixed Income Research, 1991.

Black, Fischer, and Robert Litterman. "Global Portfolio Optimization." Financial Analysts Journal 48, no. 5
(Sep/Oct 1992): 28-43.

Black, Fisher. "Universal Hedging: Optimizing currency risk and reward in international equity
portfolios." Financial Analysts Journal 45, no. 4 (1989): 16-22.

Cochrane, John H. "Portfolio advice for a multifactor world." Economic Perspectives: Federal Reserve
Bank of Chicago, Q3 1999: 59-78.

Giacometti, M., I. Bertocchi, T.S. Rachev, and F. Fabozzi. "Stable distributions in the Black-Litterman
approach to asset allocation." Quantitative Finance 7, no. 4 (2007): 423-433.

He, Guangliang, and Robert Litterman. "The Intuition Behind Black-Litterman Model Portfolios."
Goldman Sachs Investment Management Series, December 1999.

Herold, Ulf. "Portfolio Construction with Qualitative Forecasts." Journal of Portfolio Management 30, no.
1 (2003): 61-72.

Idzorek, Thomas M. "A Step-by-Step Guide to the Black-Litterman Model: Incorporating user-specified
confidence levels." Zephyr Working Document, 2004.

Krishnan, Harl, and Mains Norman. "The Two-Factor Black Litterman Model." Risk 18, no. 7 (2005): 69-
73.

Litterman, Robert. Modern Investment Management: An Equilibrium Approach. New Jersey: John Wiley
& Sons, 2003.

Meucci, Attilio. "The Black-Litterman Model: Original Model and Extensions." In The Encyclopedia of
Quantitative Finance. Wiley, 2010.

Satchell, Stephen, and Alan Scowcroft. "A Demystification of the Black-Litterman Model: Managing
Quantitative and Traditional Construction." Journal of Asset Management 1, no. 2 (2000): 138-150.

Walters, Jay. The Black-Litterman Model in Detail. 2009.

Walters, Jay. "The Factor Tau in the Black-Litterman Model." 2010.

20

Electronic copy available at: https://ssrn.com/abstract=3464770