BLACK-LITTERMAN MODEL WITH EXPLICIT VIEW CONFIDENCE

BLUMMER, FRM c 2011 TAMAS TAMAS@BLUMMERS.HU

Abstract. I introduce an explicit view condence parameter to the BlackLitterman model. The new parameter does not need calibration and eliminates other hard to quantify parameters of the original model. The discussion is supported with a side by-side calculation using data out of inuential papers on Black-Litterman model.

1. Goal The goal is to create an intuitive approach to take on active, that is relative to benchmark, risk position in a portfolio based on views on excess, that is relative to risk-free asset, returns of some assets. Black-Litterman [1] successfully addressed this problem, by starting asset allocation from the CAPM equilibrium portfolio [7] and by dening a model to blend investor views with equilibrium return to expected returns suitable for a portfolio optimizer of Markowitz [5]. The Black-Litterman model although theoretically compelling likely missed to appeal the intuition of practitioners. This is, I believe, indicated by inuential followup papers that use contradicting defaults to a parameter, ignore steps or suggest simplied view uncertainty models. See Walters [8] for a review of Black-Litterman literature, results comparison and collection of aforementioned ambiguities. The same parameters, that are hard to link to practice, imply a condence of the investor into his/her own views. This was recognized by Idzorek [3], who proposed a calibration of the model to meet those condence levels. This paper introduces an alternate denition of view condence that removes the need of calibration. The resulting model is simpler to compute and more intuitive than predecessors.

Date : 4. September 2011, First published: 22. Jun 2011.

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BLUMMER, FRM TAMAS@BLUMMERS.HU c 2011 TAMAS

2. Introduction to the Black-Litterman model Although Markowitz ideas have a lasting impact on how practitioners think about portfolio risk and return tradeo, pure and unconstrained Mean-Variance optimized portfolios are unlikely used in practice. Unconstrained portfolios of the ecient frontier are felt extreme and usually violating external constraints of asset allocation. If constraints added they usually to dominate the result. The result of Mean-Variance optimization is highly sensitive to expected excess return, for which an investor naturally does not have exact estimates. A signicant invention of the Black-Litterman model is to dene the excess return expectations to start with by implying them out of covariances and weights of the benchmark or market portfolio. Markowitz unconstrained optimization applied to a portfolio under the assumption that returns are normal distributed and their estimated future covariance matrix is , portfolio weights are w = (w1 , w2 ...wn ) such that i wi = 1, r is a corresponding vector of expected excess returns and risk aversion parameter is a scalar : (1) for which (2) is the known solution. This used in reverse as follows: (3) = wb wopt = ()1 r 1 wopt = argmax wr ww 2 w

The resulting is the equilibrium return vector for the benchmark portfolio, dened by wb , such that if would be entered into (1) in place of r it would deliver the wb as optimal. Now we have an excess return estimate that in absence of a specic investor view reproduces the benchmark. Let our investor express views on some asset returns by estimating future excess returns of specic portfolios built out of constituents of the benchmark. The view portfolios are dened as P, an m n matrix for m view portfolios on n assets of the benchmark. View matrices are naturally sparse, that is, they contain 0 for assets for which no view is expressed. A view might contain negative and positive values to express relative view on the return of two assets in a manner intuitive for practitioners for long and short positions. An example view as used in Idzoreks [3] guide to the model as follows expresses three views on a benchmark of eight

BLACK-LITTERMAN MODEL WITH EXPLICIT VIEW CONFIDENCE

assets. (4) 0 0 0 0 0 0 1 0 0 0 0 0 0 P = 1 1 0 0 0 0.9 0.9 0.1 0.1 0 0

The rst view is an outright estimate on the excess return of the seventh asset, the second is an estimate on relative outperformance of second against the rst asset and the third view favors a group of assets against an other group weighted by their capitalisation in the benchmark. The estimated returns of these view portfolios is given in a vector Q of length m. The matching example to P is: 0.0525 (5) Q = 0.0025 0.02 The model threats view return estimates as normally distributed random variables with means as in Q and variances i on the diagonal of a covariance matrix . In their combining formula of above inputs, Black-Litterman assumes that return estimates are distributed with a covariance proportional to the covariance of asset returns with where is close to zero. Their result for the expectation of r and posterior covariance is: (6) (7) E(r) = [( )1 + P 1 Q][( )1 + P 1 P]1 p = + ( )1 + P 1 P
1

The equation (6) is achived using Bayes theorem by blending prior distribution of return estimates r N (, ) with conditional Pr N (Q, ). See Walters [8] for derivation using Bayes theorem or Mankert [4] for an alternate derivation using sample theory. 3. Original model parameters While the view is intuitive to a practitioner, there is no clear guidance for and several approaches to set-up in the literature. It is however clear that their combination determine the condence the investor puts into his own view and therefore signicantly inuence the resulting portfolio. Available guidance includes He-Litterman [2] who set (8) k = pk ( )pk whereby pk is a the portfolio of the k th view from P. Their choice eliminates the dependency of the return expectation on the value of . This choice implies a condence of the view that is not under control of the investor.

BLUMMER, FRM TAMAS@BLUMMERS.HU c 2011 TAMAS

Idzorek [3] recognizes that implied view condences can be calculated if one compares the weight of the asset implied by the model while assuming that a particular view is certain, that is its variance is zero, with the weight it has with current i . He also points out that the investor might have external sources to determine per view condences and therefore the model should be calibrated to match those condences. He performs a view-by-view search for suitable k such that: (9)
ck = (wi wb,i )/(w100,i wb,i )

where 0 ck 1 is the investors condence in view k that refers to asset i, w100,i is the weight of the asset if only view k is considered but assumed to be 100% certain and wb,i is the weight of the asset i in the benchmark. While I agree from a practitioners viewpoint that investor condences into views should be matched by condences implied by the model, I think there is a simpler solution for that as I introduce in the next section. Walters [8] showed that an that satises Idzoreks [3] calibration goal can be found analytically using: (10) k = (1/ck 1)pk pk

4. The market formulation of the model Meucci rephrased the Black-Litterman model in terms of views on market returns with prior r N (, ) and leads in [6] to: (11) (12) E(r) = + P (PP + )1 (Q P ) p = P (PP + )1 P

The market formulation eliminates and is more intuitive since for no condence in views ( ) posterior variance equals prior. Meucci suggests in [6] to use a scale-independent, relative uncertainty level to dierent views as follows: (13) 1 = diag (u)PP diag (u) c

where c (0, ) is the overall level of condence in the views and u (0, )K . Note that his inherits the full covariance structure from the benchmark through PP . The new explicit view condence parameter introduced in the next section unites the ideas developed by Idzorek and Meucci into an intuitive parameter.

BLACK-LITTERMAN MODEL WITH EXPLICIT VIEW CONFIDENCE

5. The new explicit view confidence I think it is permissible to use the prior covariance of market returns in place of posterior in practice, since view condences are usually low and views are only expressed on a subset of the benchmark, therefore posterior remains close to prior. The simplication helps here to develop the idea of explicit view condence. (14) p =

Observe in (11) that Q P is the deviation of view returns from equilibrium returns as picked by P. Let us examine the deviation multiplier P [(PP )+]1 closer, since it is obviously linked to the condence the investor puts into his/her view. (15) P (PP + )1 = P (PP )1 I + (PP )1
1

With full condence in the views ( 0), we have have an expected return of: (16) E100 (r) = + P (PP )1 (Q P ) w100 = ()1 [ + P (PP )1 (Q P )] = wb + ()1 [P (PP )1 (Q P )] = wb + w

and an optimal position using (2) and (14): (17)

With increasing in relation to PP our views blur and condence decreases but will in practice not reach zero. It would be straightforward to have 0% condence by not dening the views in the rst place, implying: w0 = wb It seems intuitive to me to assume 50% condence if = PP , since: (18) (19) E50 (r) = + P (PP )1 [I + I]1 (Q P ) w50 = ()1 [ + P (PP )1 0.5(Q P )] = wb + 0.5 ()1 [P (PP )1 (Q P )] = wb + 0.5 w

It would be matching to have (20) wc = wb + c w

as the optimal position with same 0 < c 1 condence into all views, for which we need: (21) = [(cI)1 I]PP

BLUMMER, FRM TAMAS@BLUMMERS.HU c 2011 TAMAS

It is even more convenient to dene a matrix C that holds investor condences into corresponding view on its diagonal: c1 0 (22) C = 0 c2 . . . .. . Such C implies an that matches on its diagonal Walters analytical solution to Idzoreks calibration target in Meuccis market formulation of the model. The implied carries on non-diagonal elements a condence weighted covariance-like structure of the views as inherited from benchmark, but is not symmetrical. I suggest to use C as a new parameter to the model, a matrix that holds the investors explicit view condences on diagonal elements. The equation for the expected portfolio return with explicit view condence is: (23) E(r) = + P (PP )1 C(Q P )

6. Conclusion A mean-variance optimal portfolio with active risk that complies investor views of given condence and risk aversion can be obtained in a single step combining (2), (3), (23) and (14) into: (24) wopt = wb + P (PP )1 C(1 Q Pwb )

The approach introduced here uses a new intuitive parameter C, the diagonal matrix of condences of the investor into his/her own views and eliminates the hard to quantify parameters and .

Appendix A. Online resources An updated version of this paper might be available at: http://papers.ssrn. com/abstract=1870410 My calculations are reproducible with an excel spreadsheet available for download at http://www.scribd.com/doc/58531798 or by creating a Google spreadsheet using the template : http://tinyurl.com/BLWithExplicitViewConfidence

BLACK-LITTERMAN MODEL WITH EXPLICIT VIEW CONFIDENCE

Appendix B. Derivation of (24)

(25)

wopt = ()1 E(r) = ()1 [ + P (PP )1 C(Q P )] = wb + ()1 P (PP )1 C(Q P ) = wb + ()1 P (PP )1 CQ P (PP )1 CPwb = wb + P (PP )1 C1 Q P (PP )1 CPwb = wb + P (PP )1 C(1 Q Pwb )

Appendix C. Example calculations I was able to reproduce Idzoreks result using his data. Views P and Q were as already printed in previous sections. I used a risk aversion coecient of = 3.06577, = 0.025 and condences C:

(26)

0.25 0 0 0 .5 0 C = 0 0 0 0.65

The covariance matrix of benchmark assets is: (27) =

0.001005 0.001328 0.000579 0.000675 0.000121 0.000128 0.000445 0.000437 0.001328 0.007277 0.001307 0.000610 0.002237 0.000989 0.001442 0.001535 0.000579 0.001307 0.059852 0.027588 0.063497 0.023036 0.032967 0.048039 0.000675 0.000610 0.027588 0.029609 0.026572 0.021465 0.020697 0.029854

0.000121 0.002237 0.063497 0.026572 0.102488 0.042744 0.039943 0.065994

0.000128 0.000989 0.023036 0.021465 0.042744 0.032056 0.019881 0.032235

0.000445 0.001442 0.032967 0.020697 0.039943 0.019881 0.028355 0.035064

0.000437 0.001535 0.048039 0.029854 0.065994 0.032235 0.035064 0.079958

Idzorek published portfolio weights after his calibration of to investor condence. Walters reproduced Idzoreks calculation but spotted that Idzorek did not use the posterior variance as He-Litterman did and adjusted for that. Walters also used the analytical solution approach to Idzoreks calibration idea. Idzoreks and Walters published results are reprinted here side-by-side to my results using (24). Note that exact match with my result is not expected since using a dierent interpretation of investor view condence. The results however show that this new interpretation that eliminates the need of numerical model calibration and removes hard to quantify parameters leads to comparable portfolios.

BLUMMER, FRM TAMAS@BLUMMERS.HU c 2011 TAMAS

Table 1. Asset allocations Asset Benchmark Idzorek Walters Blummer 1 0.1934 0.2988, 0.296 0.312 2 0.2613 0.1559 0.158 0.1427 3 0.1209 0.0935 0.089 0.0777 4 0.1209 0.1482 0.152 0.1641 5 0.0134 0.0104 0.01 0.0086 6 0.0134 0.0165 0.017 0.0182 7 0.2418 0.2781 0.26 0.2847 8 0.0349 0.0349 0.035 0.0349

The pie chart above visually compares benchmark in the center, then Idzoreks, Walters and my results using (24) on the outer circle. Particular interest for the practitioner might be how closely the portfolios implement views, to show this I compare view portfolio expected returns with view targets for each result set. In case of Idzorek expected return after condence calibration was not published, I backed them out from nal allocation with reverse optimization as for equilibrium return.

BLACK-LITTERMAN MODEL WITH EXPLICIT VIEW CONFIDENCE

Table 2. Matching investor views Asset View target Idzorek Walters Blummer View 1 0.0525 0.0493 0.048 0.0491 View 2 0.0025 0.0043 0.004 0.0042 View 3 0.02 0.0232 0.0224 0.0217
Blummer Walters Idzorek View Target Blummer Walters Idzorek View Target Blummer Walters Idzorek View Target 0.01 0.02 0.03 0.04 0.05

The bars above visually compare how compliant approaches were with investor view. References
[1] Robert Litterman Fischer Black. Global asset allocation with equities, bonds and currencies. Goldman Sachs Fixed Income Research, 1991. [2] He and Litterman. The intuition behind black-litterman model portfolios. Goldman Sachs Fixed Income Research, December 1999. [3] Thomas M. Idzorek. A step-by-step guide to the black-litterman model, 2005. [4] Charlotta Mankert. The black-litterman model. Masters thesis, Royal Institute of Technology, Stockholm, 2006. [5] Harry Markowitz. Portfolio selection. The Journal of Finance, 7(1):7791, Mar. 1952. [6] Attilio Meucci. The black-litterman approach: Original model and extensions. http://ssrn.com/abstract=1117574, August 2010. [7] William F. Sharpe. A theory of market equilibrium under conditions of risk. The journal of Finance, 19(3):425442, Sep. 1964. [8] Jay Walters. The black-litterman model in detail. http://ssrn.com/abstract=1314585, July 2011.