The Black-Litterman (BL) model provides a framework for incorporating portfolio managers’ views into portfolio optimization. But it’s seldom used in practice and doesn’t correspond well to real-world investing.
However, things are changing, said Lior Menzly, director of quantitative research at Nomura Global Alpha LLC, speaking at the 12th annual Risk Management Conference in Muskoka, Ont.
Menzly said there are two recently developed applications that can exploit the strengths of the BL framework while simultaneously avoiding the framework’s weaknesses.
The first is concentration analysis, which allows risk management to take an active role in shaping the portfolio by finding concentrated positions and cheap hedges. Concentration analysis is actually the reverse engineering of BL; it uncovers embedded manager views in the current portfolio, continued Menzly.
The second is strategic analysis, which incorporates a forward-looking macro scenario analysis into the framework. It can be used to embed top-down views about risk factors (instead of bottom-up views on specific securities), and it maximizes expected returns in base scenarios while minimizing losses in tail events, Menzly explained.
Although the BL framework results in a stable intuitive optimal portfolio, according to Menzly, it’s costly to use from an operational standpoint. The framework asks for too much information in a form that isn’t very intuitive, he continued. The manager has to specify all views and express them through securities in the portfolio, and the challenge is to translate the manager’s views into views that are in line with the BL framework, he explained.
But despite the challenges, Menzly maintains that BL is a worthy model. “[BL] allows us as risk managers to be actively engaged in the construction of the portfolio—instead of taking a passing role.”