The Black–Litterman Approach and Views from Predictive Regressions: Theory and Implementation

Abstract

A major attraction of the Black–Litterman approach for portfolio optimization is the potential for integrating subjective views on expected returns. In this article, the authors provide a new approach for deriving the views and their uncertainty using predictive regressions estimated in a Bayesian framework. The authors show that the Bayesian estimation of predictive regressions fits perfectly with the idea of Black–Litterman. The subjective element is introduced in terms of the investors’ belief about the degree of predictability of the regression. In this setup, the uncertainty of views is derived naturally from the Bayesian regression, rather than by using the covariance of returns. Finally, the authors show that this approach of integrating uncertainty about views is the main reason this method outperforms other strategies.

TOPICS: Portfolio management/multi-asset allocation, derivatives, theory