The Black–Litterman Model for Active Portfolio Management

Abstract

Portfolio optimization presents a challenge to investors through the tendency of small differences in expected return inputs to create major swings in portfolio weightings, sometimes leading to extreme portfolio allocations. The authors believe that the Black–Litterman (BL) model can play a highly constructive role in alleviating this problem for investors, because the model combines active investment views and equilibrium views through a Bayesian approach. So that investors can fully exploit this important investment model, the authors discuss the development of the BL model within the mean-variance portfolio efficiency paradigm, examine the phenomenon of unintentional trades and additional risks related to the traditional implementation of BL in active portfolio management, and propose a potential remedy that leads to portable alpha implementation of active portfolios.

TOPICS: Portfolio construction, statistical methods, in markets