Factor Investing with Black-Litterman-Bayes: Incorporating Factor Views and Priors in Portfolio Construction

The Journal of Portfolio Management, Special Issue on Factor Investing, 2021

Posted: 3 Feb 2021

See all articles by Petter N. Kolm

Petter N. Kolm

New York University (NYU) - Courant Institute of Mathematical Sciences

Gordon Ritter

New York University (NYU) - Courant Institute of Mathematical Sciences; City University of New York (CUNY) - Weissman School of Arts and Sciences; Rutgers, The State University of New Jersey - Financial Statistics & Risk Management; New York University (NYU) - NYU Tandon School of Engineering

Date Written: November 10, 2020

Abstract

The authors propose a general framework referred to as Black-Litterman-Bayes (BLB) for constructing optimal portfolios for factor-based investing. In the spirit of the classical Black-Litterman model, the framework allows for the incorporation of investor views and different priors on factor risk premia, including data-driven and benchmark priors. Computationally efficient closed-form formulas are provided for the (posterior) expected returns and return covariance matrix that result from integrating factor views into an APT multi-factor model. In a step-by-step procedure, the authors show how to build the prior and incorporate the factor views, demonstrating in a realistic empirical example, using a number of well-known cross-sectional U.S. equity factors, that the BLB approach can add value to mean-variance optimal multi-factor risk premia portfolios.

Keywords: Factor investing, Investment analysis, Bayesian statistics, Black-Litterman, Portfolio optimization, Portfolio theory, Risk premia

JEL Classification: G11, C61, C11

Suggested Citation

Kolm, Petter N. and Ritter, Gordon, Factor Investing with Black-Litterman-Bayes: Incorporating Factor Views and Priors in Portfolio Construction (November 10, 2020). The Journal of Portfolio Management, Special Issue on Factor Investing, 2021, Available at SSRN: https://ssrn.com/abstract=3728648

Petter N. Kolm (Contact Author)

New York University (NYU) - Courant Institute of Mathematical Sciences ( email )

251 Mercer Street
New York, NY 10012
United States

Gordon Ritter

New York University (NYU) - Courant Institute of Mathematical Sciences ( email )

New York University
251 Mercer Street
New York, NY 10012
United States

City University of New York (CUNY) - Weissman School of Arts and Sciences ( email )

One Bernard Baruch Way
New York, NY 10010
United States

Rutgers, The State University of New Jersey - Financial Statistics & Risk Management ( email )

110 Frelinghuysen Road
479 Hill Center, Busch Campus
Piscataway, NJ 08854
United States

New York University (NYU) - NYU Tandon School of Engineering ( email )

6 MetroTech Center
Brooklyn, NY 11201
United States

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