The Black-Litterman Model Explained

Abstract:     
Active portfolio management is about leveraging forecasts. The Black and Litterman Global Portfolio Optimisation Model (BL) (Black and Litterman, 1992) sets forecast in a Bayesian analytic framework. In this framework, portfolio manager (PM) needs only produce views and the model translates the views into security return forecasts. As a portfolio construction tool, the BL model is appealing both in theory and in practice.

Although there has been no shortage of literature explaining it, the model still appears somehow mysterious and suffers from practical issues.

This paper is dedicated to enabling better understanding of the model itself through:
- An economic interpretation
- A clarification of the model assumptions and formulation
- An implementation guidance
- A full proof of the main result in the appendix

To make the model practical, we also discuss a dimension-reduction technique to enable large portfolio applications; and form a checklist of other practical issues that we aim to address in our forthcoming papers.

Number of Pages in PDF File: 19

Keywords: asset allocation, portfolio construction, Bayes' Rule, view blending and shrinkage, CAPM, semi-strong market efficiency, mean-variance optimisation

JEL Classification: C10, C11, C61, G11, G14

Accepted Paper Series