FINANCE 361 – Topic 6 – Black-Litterman

Paul Geertsema

1
Contents

1 Readings 3

2 What are we doing today 4

3 Problems with the Markowitz approach 5

4 Fixing Markowitz 6

5 The Black-Litterman model 7

2 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
1 Readings

• Read BKM 27.3 (the part that relates to Black-Litterman)

3 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
2 What are we doing today

• Introducing the Black-Litterman approach to portfolio optimisation

4 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
3 Problems with the Markowitz approach

• Difficult, in practice, to estimate expected returns and covariances

• Historical data is too noisy to be used
• Results in portfolios that are hard to believe
– Long positions that are multiples of the portfolio total, offset by
equally large short positions
– Results are sensitive to different ways of estimating expected
returns and covariances
• NB: If your data is noisy enough, a naive optimisation will end up
maximising the error in the data

5 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
4 Fixing Markowitz

• Various approaches to “tame” mean-variance optimisation

• Constrained optimisation
– No short sales, or only “small” short sales
– Set maximum allocation to a single asset
– Enforced Diversification
• Shrunk variance co-variance matrices
• Index methods – construct expected returns and VCV assuming
returns are driven by a linear factor model
– To implement this, one will estimate factor sensitivities for each
asset, which combined with factor expected returns, correlations
and volatilities, can be used to construct both asset VCV and
expected returns.
• Black-Litterman
6 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
5 The Black-Litterman model

• Originally developed at Goldman Sachs

• Published in 1992, with ongoing contributions in the 90’s and
2000’s
• Markowitz approach
– Estimate returns, covariances
– Then calculate optimal portfolio
– If the market allocation is different, then the market is “wrong”

7 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 The Black-Litterman model (cont.)

• The Black-Litterman model is sophisticated; quoting from Idzorek

(2005), the Black Litterman model combines
– the CAPM (Sharpe 1964)
– Reverse optimisation (Sharpe 1974)
– Mixed estimation (Theil 1971,1978)
– the universal hedge ratio/global CAPM (Black 1989)
– mean variance optimization (Markowitz 1952)

8 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 The Black-Litterman model (cont.)

• Black-Litterman approach
– Assume the market is “right”
– Then the Markowitz optimal portfolio should also be the market
portfolio
– Set optimal portfolio = market portfolio and solve for the market
implied expected returns, covariances
– Then adjust the expected returns to reflect your own views, if
different from those implied by the market
◦ NB: Changing one expected return also affects other expected
returns (via the VCV). The Black-Litterman approach takes
care of this.
– Re-optimise using the Markowitz approach with the BL VCV
and BL expected returns
– The above describes the underlying ideas; the actual implement-
ation is more complicated (see the Appendix in Ch 27 of BKM)

9 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 The Black-Litterman model (cont.)

• Schematic (courtesy of JPMorgan, sourced from here )

10 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema