1. Asset Management Lecture 9

2. Outline for today Black-litterman model and sensitivity in confidence Treynor-Black vs Black-Litterman Value of active management

3. The Black-Litterman Model Step 1: Estimate the covariance matrix from historical data Step 2: Determine a baseline forecast Step 3: Integrating the manager’s private views Step 4: Developing revised (posterior) expectations Step 5: Apply portfolio optimization

4. Sensitivity in confidence level

5. Figure 27.5 Sensitivity of Black-Litterman Portfolio Performance to Confidence Level (view is correct)

6. Treynor-Black vs Black-Litterman TBBL Maximizationidentical

7. 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

8. 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)

9. The BL Model as Icing on the TB Cake Use BL to include forecasts from comparative economic and international finance analyses Input list for BL model

10. 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

11. The BL Model as Icing on the TB Cake The BL model could be viewed as a generalization of the TB model Differences?

12. Treynor-Black vs Black-Litterman TBBL Maximizationidentical inputIndividual security analysis Views of relative performance targetSecurity analysis with adjustment of forecasts Asset allocation where relative performance is relevant.

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

14. 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.