Asset Management

Asset Management

Lecture 9

Outline for today

Black-litterman model and sensitivity in confidence

Treynor-Black vs Black-LittermanValue of active management

The Black-Litterman Model

Step 1: Estimate the covariance matrix from historical data

Step 2: Determine a baseline forecastStep 3: Integrating the manager’s private

viewsStep 4: Developing revised (posterior)

expectationsStep 5: Apply portfolio optimization

Sensitivity in confidence level

Confidence measured by standard deviation of view QPossible SD 0 0.0100 0.0173 0.0300 0.0600Variance 0 0.0015 0.0003 0.0009 0.0036

E(RB|P) 0.0190 0.0148 0.0164 0.0152 0.0143

E(RS|P) 0.0140 0.0598 0.0424 0.0556 0.0643

Figure 27.5 Sensitivity of Black-Litterman Portfolio

Performance to Confidence Level (view is correct)

Treynor-Black vs Black-Litterman

TB BL

Maximization identical

The BL Model as Icing on the TB Cake

Suppose that you have two portfolios—one for the US and one for Europe The model would be run as two separate divisions Each division would compile values of alpha

relative to their own passive portfolio Portfolios need to be optimized separately Relative performance of the two markets can be

expected to add information to the independent macro forecasts for the two economies

The BL Model as Icing on the TB Cake

Use BL to include forecasts from comparative economic and international finance analyses Replace TB alpha with BL views Example: assume only one stock in the active

portfolio Alpha, beta, E(Rm), var(Rm), var(e)

The BL Model as Icing on the TB Cake

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Use BL to include forecasts from comparative economic and international finance analyses Input list for BL model

TttetRatRSCL M ),()()(:

The BL Model as Icing on the TB Cake

Use BL to include forecasts from comparative economic and international finance analyses Calculate the conditional expected return will give

you the same results as from the TB model: The realized abnormal return of time T

The precision of record, t<T

Adjust

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The BL Model as Icing on the TB Cake

The BL model could be viewed as a generalization of the TB model

Differences?

Treynor-Black vs Black-Litterman

TB BL

Maximization identical

input Individual security analysis

Views of relative performance

target Security analysis with adjustment of forecasts

Asset allocation where relative performance is relevant.

Value of Active Management

Model for estimation of potential fees Kane, Marcus, and Trippi (JPM, 1999) The percentage fee, f, that investors would be willing

to pay for active services

Source of the power of the active portfolio the squared information ratios

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Remember f is in addition to what an index fund would charge.

Concluding Remarks

The gap between theory and practice has been narrowing in recent years

TB model is sensitive to large alpha values

BL model relies on the “confidence” level which is often ambiguous.