Global Asset Allocation With Equities, Bonds, and Currencies

Discussion in 'Educational Resources' started by ASusilovic, Dec 2, 2007.

  1. Goldman Sachs

    Fixed Income Research, 1991

    Fischer Black
    Robert Litterman

    Executive Summary

    A year ago, Goldman Sachs introduced a quantitative model that
    offered an innovative approach to the management of fixed income
    portfolios.* It provided a mechanism for investors to make global
    asset allocation decisions by combining their views on expected
    returns with Fischer Black’s “universal hedging” equilibrium. Given
    an investor’s views about interest rates and exchange rates,
    this initial version of the Black-Litterman Global Asset Allocation
    Model has been used to generate portfolios with optimal weights
    in bonds in different countries and the optimal degree of currency
    In this paper, we describe an updated version of the Black-
    Litterman Model that incorporates equities as well as bonds and
    currencies. The new version of the model will be especially useful
    to portfolio managers who make global asset allocation decisions
    across equity and fixed income markets, but it will also have advantages
    for pure fixed income managers.
    The addition of the equity asset class to the model allows us to use
    an equilibrium based on both bonds and equities. This equilibrium
    is more desirable from a theoretical standpoint because it incorporates
    a larger fraction of the universe of investment assets. In our
    model (as in any Capital Asset Pricing Model equilibrium), the
    equilibrium expected excess return on an asset is proportional to
    the covariance of the asset’s return with the return of the market
    portfolio. Even for pure fixed income managers, it is useful to use
    as broad a measure of the “market portfolio” as is practical.
    As we described in our earlier paper, the equilibrium is important
    in the model because it provides a neutral reference point for
    expected returns. This allows the investor to express views only
    for the assets that he desires; views for the other assets are derived
    from the equilibrium. By providing a center of gravity for
    expected returns, the equilibrium makes the model’s portfolios
    more balanced than those from standard quantitative asset allocation
    models. Standard models tend to choose unbalanced portfolios
    unless artificial constraints are imposed on portfolio composition.

    I. Introduction

    Investors with global portfolios of equities and bonds are Igenerally aware that their asset allocation decisions —
    the proportions of funds that they invest in the asset
    classes of different countries and the degrees of currency
    hedging —are the most important investment decisions they
    make. In attempting to decide on the appropriate allocation,
    they are usually comfortable with the simplifying assumption
    that their objective is to maximize expected return for
    any given level of risk, subject in most cases to various types
    of constraints.
    Given the straightforward mathematics of this optimization
    problem, the many correlations among global asset classes
    required in measuring risk, and the large amounts of money
    involved, one might expect that in today’s computerized
    world, quantitative models would play a dominant role in
    this global allocation process.
    Unfortunately, when investors have tried to use quantitative
    models to help optimize this critical allocation decision, the
    unreasonable nature of the results has often thwarted their
    efforts.2 When investors impose no constraints, asset
    weights in the optimized portfolios almost always ordain
    large short positions in many assets. When constraints rule
    out short positions, the models often prescribe “corner” solutions
    with zero weights in many assets, as well as unreasonably
    large weights in the assets of markets with small capitalizations.
    These unreasonable results have stemmed from two wellrecognized
    problems. First, expected returns are very difficult
    to estimate. Investors typically have views about absolute
    or relative returns in only a few markets. In order to
    use a standard optimization model, however, they must state
    a set of expected returns for all assets and currencies. Thus,
    they must augment their views with a set of auxiliary assumptions, and the historical returns that portfolio managers
    often use for this purpose provide poor guides to future
    Second, the optimal portfolio asset weights and currency
    positions in standard asset allocation models are extremely
    sensitive to the expected return assumptions. The two problems
    compound each other because the standard model has
    no way to distinguish strongly held views from auxiliary
    assumptions, and given its sensitivity to the expected returns,
    the optimal portfolio it generates often appears to
    have little or no relation to the views that the investor wishes
    to express.
    Confronting these problems, investors are often disappointed
    when they attempt to use a standard asset allocation model.
    Our experience has been that in practice, despite the obvious
    conceptual attractions of a quantitative approach, few global
    investment managers regularly allow quantitative models to
    play a major role in their asset allocation decisions.

    In this paper we describe an approach that provides an
    intuitive solution to these two problems that have plagued
    the use of quantitative asset allocation models. The key to
    our approach is the combining of two established tenets of
    modern portfolio theory: the mean-variance optimization
    framework of Markowitz (1952) and the capital asset pricing
    model (CAPM) of Sharpe (1964) and Lintner (1965). We
    allow the investor to combine his views about the outlook for
    global equities, bonds, and currencies with the risk premiums
    generated by Black’s (1989) global version of the CAPM
    equilibrium. These equilibrium risk premiums are the excess
    returns that equate the supply and demand for global assets
    and currencies.
  2. 44 pages? Suss, next time, please just give a three sentence summation of the paper. :p
  3. Summation of the paper ?, no, no !...ET members need the challenge, the inner conviction to work hard for becoming superior traders, money managers, survivors ( of the fittest )....:D