Vivan Maheshwari 2766333

Ankur Sharma 6151600

Black-Litterman Implementation Document

BackgroundOptimal asset allocation approached within a Markowitz Portfolio Theory (MPT)
framework can result in positions that are completely unrealistic. These
unrealistic portfolio weights are a result of two things- using past returns as a
proxy for expected returns, and high covariances between assets. Small changes
in expected returns can thus result in drastically different portfolios.
The Black-Litterman model does not require expected returns of the assets as
input, rather, it requires the markets allocation of the assets (weighted by
market capitalisation). It assumes this market portfolio is optimal, and finds the
markets expected returns on the individual assets. These expected returns are
adjusted based on individual opinions, and finally it is these adjusted expected
returns that are used to derive the Black-Litterman optimal portfolio (in the same
way as MPT).
The Black-Litterman ImplementationThis section provides information on the accompanying Excel spreadsheet with
an implemented Black-Litterman model. The world of assets is taken to be 5 ETFs
from major regions around the world, with portfolio benchmark proportions
weighted by GDP, as shown in the Input tab.
To implement the model, we need to import monthly data from the 5 ETFs into
our spreadsheet, for the 5 years to December 2013. The tabs ILF, EWJ, EZU,
FXI and SPY show the raw financial data extracted from Yahoo Finance. We are
interested in the adjusted closing prices (they account for dividends, stock splits,
etc), which are shown in the YahooReturns tab. These adjusted closing prices
are copied to the PriceInput tab- from this all of our calculations can be done.
The Black-Litterman model also requires other inputs: the risk-free rate (T-Bill
rate is used in this implementation- 0.17%), the expected monthly portfolio
return (0.46%), the shrinkage factor, and any adjustments to the expected return
on a particular asset (the client believes the US will underperform by 0.083%
monthly).
The Black-Litterman model relies on some crucial assumptions, which are the
detailed in the Assumptions tab. The basis for the theory is that it is very
difficult to outperform the market portfolio, hence it is assumed optimal, and the
expected returns are computed from these market portfolio weights (essentially
the reverse of MPT).
The Returns tab shows the continuously compounded monthly returns based on
the price data, and from this the mean return, volatility and variance can be
computed. These are shown at the top of the Returns tab for each ETF.
The VCV tab computes the variance-covariance matrix for the 5 ETFs. On the
diagonal elements of the matrix are the variances of the ETFs, and on the nondiagonal elements are the corresponding covariances between different ETFs.
The VCV matrix can be quickly computed using matrix multiplication, as shown in
the formula in the VCV range in the same tab.

Vivan Maheshwari 2766333

Ankur Sharma 6151600
This matrix forms the basis of Markowitz Portfolio Theory, and the optimal
portfolio using this theory has been calculated at the bottom of the VCV tab
using matrix multiplication giving a weights vector:
Matrix multiplication of the inverted VCV and Excess Returns
Sum of the matrix multiplication of the inverted VCV and Excess Return
Clearly, the positions taken in this portfolio are unreasonable (219% in US
equities, this does not account for the fact that the client believes US equities
will underperform), and provides an example of why the Black-Litterman
approach is preferred in the first place.
One of the reasons that MPT fails is because the covariances between the ETFs
are reasonably high, so if we introduce a shrinkage factor which reduces the
covariance terms in the VCV matrix we could get a more realistic portfolio
allocation. The shrinkage factor used (refer to the Input tab) was 0.3 and
resulted in the shrunk VCV matrix shown in the Black-Litterman tab. Note that
only the covariances are shrunk by a factor of 0.3, the variances are all the same
as the original VCV. Using MPT again, we arrive at the shrunk optimal portfolio,
which has much more realistic allocation weights.
However, the fact remains that using historical data as a proxy for future
expected returns is not always an accurate representation. The final BlackLitterman model provides a solution to this problem. In traditional MPT above,
the portfolio weights were determined by using the VCV and our expected (but
really historical) excess return matrices to arrive at the portfolio weights. The
Black-Litterman approach starts by using the VCV and market portfolio weights
to determine the expected returns vector.
These expected returns are shown under BL Expected Returns in the BlackLitterman tab. These values are clearly different to the mean returns of the past
5 years of monthly returns. However the expected portfolio return is slightly
different to the one assumed for the market portfolio. Thus a normalising factor
must be introduced, which results in the same expected return on the portfolio
as the market return prediction in the Assumptions tab. These individual
expected returns are shown under Normalised BL Expected Returns in the
Black-Litterman tab.
From these expected returns, we can calculate the optimal portfolio in the same
way as in MPT. The returns used are not historic, so they essentially form the
markets view of how these individual assets will perform. If we use these
expected returns and the VCV in the same way as MPT we could find the optimal
portfolio. However, it is clear that would result in the same optimal portfolio
weights as the market portfolio weights, since the assumption of Black-Litterman
is that the market portfolio is optimal. Thus, if the user of the model agrees with
the expected returns predicted, the optimal portfolio is simply the market
portfolio.
The Black-Litterman model thus accounts for individual opinions. The client
believes that US equites will underperform expectations by 1% p.a (0.083%
monthly), thus the model includes the functionality to adjust US expected returns
by this amount. The issue with this however, is that if the US returns differ from
expectations, we can expect the other returns to differ from their predictions.

Vivan Maheshwari 2766333

Ankur Sharma 6151600
This is because the returns are correlated. The formula used to determine the
opinion adjusted returns (in the Black-Litterman tab) is displayed under Opinion
Adjusted Returns. This can be concisely calculated by creating a matrix of
Tracking Factors, which displays the ratio of covariances to the variances of the
assets.
It is the opinion adjusted returns that are now used as inputs to a traditional MPT
optimisation process. By using the same formula as in MPT we can find the
weights of the portfolio with the original VCV and the new opinion adjusted
returns. These portfolio weights are under Optimised Benchmark Proportions in
the BlackLitterman tab. It is this portfolio that is the Black-Litterman optimised
portfolio.

SummaryTraditional MPT uses historic returns and the VCV matrix to find optimal portfolio
weights. This can result in unrealistic portfolios. The Black-Litterman approach
uses the market portfolio and the VCV matrix to find the markets expected
returns for each portfolio component. These returns can be adjusted according to
individual opinions about particular assets. The final opinion adjusted returns and
the VCV are used to calculate the Black-Litterman optimal portfolio. The final
portfolio weights are very reasonable, and intuitively since the client has a lower
expectation of US returns, the portfolio contains a short position in US equities.