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Financial Analysts Journal
Fischer Black and particular view influences These unreasonable results stem
Robert Litterman portfolio weights, in accor- from two well recognized prob-
lems. First, expected returns are
dance with the degree of
very difficult to estimate. Inves-
confidence with which he tors typically have knowledgeable
Quantitative asset alloca-
holds the view. views about absolute or relative
tion models have not
returns in only a few markets. A
played the important role standard optimization model,
they should in global port- however, requires them to pro-
folio management. A good Investors with global portfolios of vide expected returns for all as-
equities and bonds are generally sets and currencies. Thus inves-
part of the problem is that
aware that their asset allocation tors must augment their views
such models are difficult to decisions-the proportions of with a set of auxiliary assump-
use and tend to result in funds they invest in the asset tions, and the historical returns
portfolios that are badly classes of different countries and they often use for this purpose
behaved. the degrees of currency hedg- provide poor guides to future re-
ing-are the most important in- turns.
Consideration of the global vestment decisions they make. In
CAPM equilibrium can sig- deciding on the appropriate allo- Second, the optimal portfolio as-
cation, they are usually comfort- set weights and currency posi-
nificantly improve the use- able making the simplifying as-
tions of standard asset allocation
fulness of these models. In sumption that their objective is to models are extremely sensitive to
particular, equilibrium re- maximize expected return for a the return assumptions used. The
turns for equities, bonds given level of risk (subject, in two problems compound each
and currencies provide most cases, to various types of other; the standard model has no
neutral starting points for constraints). way to distinguish strongly held
views from auxiliary assumptions,
estimating the set of ex-
Given the straightforward mathe- and the optimal portfolio it gen-
pected excess returns matics of this optimization prob- erates, given its sensitivity to the
needed to drive the portfo- lem, the many correlations expected returns, often appears
lio optimization process. among global asset classes re- to bear little or no relation to the
This set of neutral weights quired in measuring risk, and the views the investor wishes to ex-
large amounts of money involved, press. In practice, therefore, de-
cn
can then be tilted in accor-
one might expect that, in today's spite the obvious conceptual
dance with the investor's
computerized world, quantitative attractions of a quantitative ap-
views. models would play a dominant proach, few global investment
LU
Expected excess returns. pected returns move away from views into a set of expected re-
0
their equilibrium values, imbal- turns for all assets and currencies. co
*Neutral Portfolio: ances in markets will tend to push We then follow with a set of ap-
uJ
La
An optimal portfolio given them back. We thus think it is plications of the model that illus- H
neutral views. reasonable to assume that ex- trate how the equilibrium solves 2
lU
VI
pected returns are not likely to the problems that have tradition-
z
NoNeutral Views: deviate too far from equilibrium ally led to unreasonable results in D
Means when the investor has values. This suggests that the in- standard mean-variance models. 0
The portfolio that an investor contained in equilibrium pricesglobal equilibrium model to help -j
feels comfortable with when and returns. make his global asset allocation u
z
he has no views. He can use decision? A neutral reference is a
z
the normal portfolio to infer a Our approach distinguishes be- critically important input in mak-
benchmark when no explicit ing use of a mean-variance opti-
twveen the views of the investor
benchmark exists. and the expected returns that mization model, and an equilib- 29
France
Equities 0.52 0.17 0.03 1.00
Bonds 0.23 0.46 0.15 0.36 1.00
Currency 0.03 0.33 0.92 0.08 0.15 1.00
Japan
Equities 0.37 0.15 0.05 0.42 0.23 0.04 1.00
Bonds 0.10 0.48 0.27 0.11 0.31 0.21 0.35 1.00
Currency 0.01 0.21 0.62 0.10 0.19 0.62 0.18 0.45 1.00
UK
Equities 0.42 0.20 -0.01 0.50 0.21 0.04 0.37 0.09 0.04
Bonds 0.14 0.36 0.09 0.20 0.31 0.09 0.20 0.33 0.19
Currency 0.02 0.22 0.66 0.05 0.05 0.66 0.06 0.24 0.54
Us
Equities 0.43 0.23 0.03 0.52 0.21 0.06 0.41 0.12 -0.02
Bonds 0.17 0.50 0.26 0.10 0.33 0.22 0.11 0.28 0.18
Canada
Equities 0.33 0.16 0.05 0.48 0.04 0.09 0.33 0.02 0.04
Bonds 0.13 0.49 0.24 0.10 0.35 0.21 0.14 0.33 0.22
Currency 0.05 0.14 0.11 0.10 0.04 0.10 0.12 0.05 0.06
Australia
Equities 0.34 0.07 -0.00 0.39 0.07 0.05 0.25 -0.02 0.12
Bonds 0.24 0.19 0.09 0.04 0.16 0.08 0.12 0.16 0.09
Currency -0.01 0.05 0.25 0.07 -0.03 0.29 0.05 0.10 0.27
Equities Bonds Currency Equities Bonds Equities Bonds Currency Equities Bonds
UK
Equities 1.00
Bonds 0.47 1.00
Currency 0.06 0.27 1.00
US.
Equities 0.58 0.23 -0.02 1.00 an
Bonds 0.12 0.28 0.18 0.32 1.00
Canada LU
Australia LU
Equities 0.50 0.20 0.15 0.48 -0.05 0.61 0.02 0.18 1.00
LU
Bonds 0.17 0.17 0.09 0.24 0.20 0.21 0.18 0.13 0.37 1.00
Currency 0.06 0.05 0.27 0.07 -0.00 0.19 0.04 0.28 0.27 0.20
4:
z
31
-J
risk measure is simply the volatil- is no better. One problem with This approach, and the others we
z
ity of asset returns. Currencies in this approach is that it hasn't have so far used, are based on
this case are assumed to have no taken the correlations of the asset what might be called the "de-
excess return. Table V shows the 4:
returns into account. But there is mand for assets" side of the equa-
optimal portfolio for this case. z
another problem as well-per- tion-that is, historical returns
Now we have incorporated vola- haps more subtle, but also more and risk measures. The problem
tilities, but the portfolio behavior serious. with such approaches is obvious
well-behaved portfolios, without Equities (%) 3.7 6.3 27.2 14.5 -30.6 24.8 6.0
erage value of RA - RB from these fidence in a view, we use this dent, depending on which ap- UJ
data is Q. In this special case, we conditional mean as our vector of proach is used to think about LU
can represent the view as a linear expected excess returns. subjective views. The appendix H
{E[R,j, E[RB], E[RJ} conditional Germany France Japan UK US. Canada Australia
z
on the equilibrium and this infor-
Currency 1.4 1.1 7.4 2.5 0.8 0.3
mation. This is a relatively z
Exposure (%)
straightforward problem from
Bonds (%) 3.6 2.4 7.5 2.3 67.0 1.7 0.3
multivariate statistics. To simplify, Equities (%) 3.3 2.9 29.5 10.3 3.3 2.0 1.4
assume a normal distribution for 35
Three-Month Horizon
Expected Future Yields 8.8 9.5 6.5 10.1 8.4 10.1 10.8
Annualized Expected
Excess Returns -3.31 -5.31 1.78 1.66 -3.03 -3.48 5.68
gives the formula for the ex- exceeds that of B by more than it own independent shock. Al-
pected excess returns that com- does in equilibrium. From this, though we should impute some
bine views with equilibrium in we clearly ought to impute that a change in the factor from the
the general case. shock to the common factor is the higher return of A relative to B,
most likely reason A will outper- the impact on C should be less
Now consider our example, in form B. If so, C ought to perform than in the previous case.
which asset correlations result better than equilibrium as well.
from the impact of one common The conditional mean in this case In this case, the conditional mean
factor. In general, we will not is [3.9, 1.9, 2.9]. Indeed, the inves- is [2.3, 0.3, 1.3]. Here the implied
know the impacts of the factor on tor's view of A relative to B has effect of the common-factor shock
the assets-that is, the values of raised the expected return on C on asset C is lower than in the
yA, yB and yYc But suppose the by 1.9 percentage points. previous case. We may attribute
unknown values are [3, 1, 2]. Sup- most of the outperformance of A
pose further that the independent But now suppose the indepen- relative to B to the independent
shocks are small, so that the assets dent shocks have a much larger shocks; indeed, the implication
are highly correlated with volatil- impact than the common factor. for E[RB] is negative relative to
ities approximately in the ratios Let the I matrix be as follows: equilibrium. The impact of the
3:1:2. independent shock to B is ex-
19.0 3.0 6.0 pected to dominate, even though
Suppose, for example, the covari- the contribution of the common
(r 3.0 11.0 2.0
ance matrix is as follows: factor to asset B is positive.
6.0 2.0 14.0]
0)
Note that we can identify the im-
LU
m
LU [9.1 3.0 6.0
Suppose the equilibrium risk pre- pact of the common factor only if
0 3.0 1.1 2.0
miums are again given by [1, 1, 1]. we assume that we know the true
U 6.0 2.0 4.1 Now assume the investor expects structure that generated the cova-
0~
that A will outperform B by 2%. riance matrix of returns. That is
LU
Assume also, for simplicity, that true here, but it will not be true in
the percentage equilibrium risk This time, more than half of the general. The computation of the
z
premiums are equal-for exam- volatility of A is associated with its conditional mean, however, does
VI
D ple, [1, 1, 1]. There is a set of
:: market capitalizations for which
-J that is the case.
r-J Table XII Optimal (Unconstrained) Portfolio Based on Economists'
U Views
z Now consider what happens
when the investor expects A to
: Germany France Japan UK US Canada Australia
outperform B by 2%. In this ex-
Currency 16.3 68.8 -35.2 -12.7 29.7 -51.4
Z ample, virtually all of the volatility
z Exposure (%)
of the assets is associated with Bonds (%) 34.5 -65.4 79.2 16.9 3.3 -22.7 108.3
movements in the common fac- Equities (%) -2.2 0.6 6.6 0.7 3.6 5.2 0.5
36 tor, and the expected return of A
the third asset because of the In the previous section, we illus- able when it is used simply to
uncertainty of the view. trated how our approach allows make the model better behaved. LU
ax
crease the domestic weight of its In this type of analysis, different returns. Historical analyses con- a'
portfolio to 85% from the current benchmarks may imply very dif- tinue to be used in this context
Lr
market capitalization of 45%, and ferent views for a given portfolio. simply because investment advis- 0a
U
not wishing to hedge the cur- Table XVII shows the implied ers argue there is nothing better m
0
rency risk of the remaining 15%
in international markets, might LU
consider an alternative portfolio Table XVIII The Value of Global Diversification (expected excess LU
LU
such as the one shown in Table returns in equilibrium at a constant 10.7% risk)
XV. The higher domestic weights
~:
lead to an annualized volatility 0.4 Basis-Point Percentage z
Once an investor has established Bonds and Equities 4.76 5.61 85 17.9
his objectives, an asset allocation 39
m with and without allowing cur- tion but are generated using sim-
equities of countries with high
LLI rency hedging). We normalize ilar approaches. In simulations of
.u ratios of dividend yield to bond
the portfolio volatilities at the high-yielding currency strat-
yield.
10.7%-the volatility of the mar- egy, our views are based on the
H
z
L#) ket-capitalization-weighted port- assumption that the expected ex-
-J
w folio, 80% hedged. Table XVIII Our purpose is to illustrate how a cess returns from holding a for-
shows the additional return avail- quantitative approach can be eign currency are above their
able from including international used to make a useful compari- equilibrium value by an amount
Z:
assets relative to the optimal do- son of alternative investment equal to the forward discount on
mestic portfolio with the same strategies. We are not trying to that currency.
degree of risk. promote or justify a particular
U strategy. We have chosen to focus For example, if the equilibrium
z
What is clear from this table is on these three primarily because risk premium on yen, from a U.S.
z
-
that global diversification pro- they are simple, relatively compa- dollar perspective, is 1% and the
vides a substantial increase in ex- rable, and representative of stan- forward discount (which, because
40 pected return for the domestic dard investment approaches. of covered interest rate parity,
00 X t ~~~~~~~~~~Equity Strategy|
expected excess returns on cur-
200 - Bond Strategy
rencies and bonds by assuming
100% confidence in these views
for equities and adjusting the re-
turns away from equilibrium in
the appropriate manner.
0u
in that country to be 3 %. We 0-
z
compute expected excess returns 0 2 4 6 8 10 12 14 16
on currencies and equities by as-
suming 100% confidence in these Risk (%) 41
appendix.
Ftt +1 - t1 1
FXt= ' 100, 13. A 'prime" symbol (e.g., P') indicates co
xt a transposed vector or matrix. :
where F't+' is the one-periodfor- (New York: Wiley and Sons, 1971). LX
80% currency-hedged portfolio that 16 For details of these views, see the
will be held in equilibrium in our following Goldman Sachs publica- z
model. tions: The International Fixed In-
-J
7. For the purposes of this exercise, we come Analyst August 2, 1991, for
interest rates and The International U
arbitrarily assigned to each country z
the average historical excess return Economics Analyst, July/August
z
across countries, as follows-.2 for 1991, for exchange rates. L4
currencies, 0.4 for bonds and 5.1 17. We discuss this situation later.
for equities. 18. Black, "Universal Hedging," Op. Cit 43