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Asset Management. Lecture 9. Outline for today. Black-litterman model and sensitivity in confidence Treynor-Black vs Black-Litterman Value of active management. The Black-Litterman Model. Step 1: Estimate the covariance matrix from historical data Step 2: Determine a baseline forecast

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outline for today
Outline for today
  • Black-litterman model and sensitivity in confidence
  • Treynor-Black vs Black-Litterman
  • Value of active management
the black litterman model
The Black-Litterman Model

Step 1: Estimate the covariance matrix from historical data

Step 2: Determine a baseline forecast

Step 3: Integrating the manager’s private views

Step 4: Developing revised (posterior) expectations

Step 5: Apply portfolio optimization

slide5
Figure 27.5 Sensitivity of Black-Litterman Portfolio Performance to Confidence Level (view is correct)
the bl model as icing on the tb cake
The BL Model as Icing on the TB Cake
  • Suppose that you have two portfolios—one for the US and one for Europe
    • The model would be run as two separate divisions
    • Each division would compile values of alpha relative to their own passive portfolio
    • Portfolios need to be optimized separately
    • Relative performance of the two markets can be expected to add information to the independent macro forecasts for the two economies
the bl model as icing on the tb cake1
The BL Model as Icing on the TB Cake
  • Use BL to include forecasts from comparative economic and international finance analyses
    • Replace TB alpha with BL views
    • Example: assume only one stock in the active portfolio
      • Alpha, beta, E(Rm), var(Rm), var(e)
the bl model as icing on the tb cake2
The BL Model as Icing on the TB Cake
  • Use BL to include forecasts from comparative economic and international finance analyses
    • Input list for BL model
the bl model as icing on the tb cake3
The BL Model as Icing on the TB Cake
  • Use BL to include forecasts from comparative economic and international finance analyses
    • Calculate the conditional expected return will give you the same results as from the TB model:
      • The realized abnormal return of time T
      • The precision of record, t<T
      • Adjust
the bl model as icing on the tb cake4
The BL Model as Icing on the TB Cake
  • The BL model could be viewed as a generalization of the TB model
  • Differences?
value of active management
Value of Active Management

Remember f is in addition to what an index fund would charge.

  • Model for estimation of potential fees
    • Kane, Marcus, and Trippi (JPM, 1999)
    • The percentage fee, f, that investors would be willing to pay for active services
    • Source of the power of the active portfolio
      • the squared information ratios
concluding remarks
Concluding Remarks

The gap between theory and practice has been narrowing in recent years

TB model is sensitive to large alpha values

BL model relies on the “confidence” level which is often ambiguous.