united kingdomen
Refining the inclusion of views in portfolio construction

Refining the inclusion of views in portfolio construction

09-10-2019 | 5-Year outlook

Taking investors’ views into account when building portfolios is difficult but essential, says Roderick Molenaar.

  • Roderick  Molenaar
    Roderick
    Molenaar
    Portfolio Strategist

Speed read

  • Black-Litterman model accounts for confidence or uncertainty
  • Three-step approach to derive, input and combine views
  • Additional step needed to include qualitative views

A key use of our Expected Returns publication is to build portfolios that are aligned with our views in order to achieve the best investment results. As investors often use input from different sources to optimize their portfolios, translating their views on all the respective assets is no mean feat.

In particular, one needs to define point estimates for each asset class, as well as have a similar confidence in these estimates. For example, do investors have the same level of confidence in their view on interest rates as they do in their view on stocks? What if they do not have a view on all the assets in the investment universe? And what, for example, would be the best course of action if one asset class were expected to outperform another by a certain degree?

These questions are not new, and unsurprisingly, a great deal of work and research has gone into developing toolkits to help answer them. A major breakthrough came in the early 1990s, when Fischer Black and Robert Litterman wrote two papers introducing a methodology for portfolio allocation that explicitly takes into account investors’ confidence or uncertainty with respect to their own views of markets.

Expected Returns 2020-2024 is now available
Download the full report

The Black-Litterman model

The approach is based on the recognition that, unlike in physics, there is no certainty when it comes to the financial markets. For example, to estimate the excess return of equities over the risk-free rate, we can use a historical average. Using realized returns for the MSCI World Index, starting in 1969, the average annual excess return equals 5.2%. Given the length of the data set, this seems like a good neutral approximation of what to expect in terms of excess return.

However, there is always a chance that the average has been calculated using a sample that does not fully represent the true characteristics. The standard error of the mean is 2.5%. Therefore, we can say that our expected average annual excess return for equities will likely lie between 2.7% and 7.7%.

However, in practice the 5.2% point estimate is often used without taking the accompanying uncertainty into account. The Black-Litterman model addresses these flaws and tries to improve on them using a three-step approach.

Step 1 – derive the implied views: The logical starting point for any portfolio construction approach is the benchmark. A benchmark should fit an investor’s objectives, and often represents the optimal long-term asset allocation. The first step in the Black-Litterman model is therefore to derive the ‘implied’ views from the benchmark.

These ‘implied’ returns justify the benchmark weighting of each class. If the returns do not match the investor’s long-term expectations, this should have consequences for the benchmark. This part of the model is in itself quite useful for most investors.

Step 2 – input the actual views: In the second step, investors give their views on (a selection of) the assets. Besides the views, the level of confidence in the views must be input for the model. If confidence in a certain view is low, the specific view will have a low impact on asset allocation in the portfolio; if it is high, it may have a significant impact.

For portfolio construction, this approach is very appealing as it eliminates the need to input views in a certain format; views can be provided on not only the absolute but also the relative performance of assets. Besides it is sufficient to provide views only on a subset of the assets.

Step 3 – combine the views: Having calculated the views implied by the benchmark and our actual views, we combine them. For this, we use what is known as a ‘Bayesian framework’. This is a statistical toolkit that enables us to determine the return views based on implied views and actual quantitative views. These combined views will subsequently be the input for the optimization approach.

An example of combining implied and actual views where confidence is not equal

Source: Robeco

Enhancements to the model

The Black-Litterman model requires us to input point estimates of our expected returns and the level of confidence assigned to those views. In practice, these requirements can reduce the effectiveness of the approach, especially when it is hard to summarize the information into the point estimates.

Therefore, we have enhanced the model to make it more accessible. Often strategists or investment committees first rank assets either in relative terms, e.g. ‘asset A will outperform asset B’, or in absolute terms, e.g. ‘rates will increase more than forwards’. Transforming these qualitative views into more quantitative ones, e.g. ‘asset A will outperform asset B by 2.5%’, and also quantifying the confidence investors have in the views can be challenging.

An approach that eliminates the need to translate qualitative views into quantitative ones is therefore desirable. We believe that this additional step enables investors to better express their views in their asset allocation.

Expected Returns 2020-2024
Expected Returns 2020-2024
Read all articles
Subjects related to this article are:

Disclaimer

Please read this important information before proceeding further. It contains legal and regulatory notices relevant to the information contained on this website.

The information contained in the Website is NOT FOR RETAIL CLIENTS - The information contained in the Website is solely intended for professional investors, defined as investors which (1) qualify as professional clients within the meaning of the Markets in Financial Instruments Directive (MiFID), (2) have requested to be treated as professional clients within the meaning of the MiFID or (3) are authorized to receive such information under any other applicable laws. The value of the investments may fluctuate. Past performance is no guarantee of future results. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency.

In the UK, Robeco Institutional Asset Management B.V. (“ROBECO”) only markets its funds to institutional clients and professional investors. Private investors seeking information about ROBECO should visit our corporate website www.robeco.com or contact their financial adviser. ROBECO will not be liable for any damages or losses suffered by private investors accessing these areas.

In the UK, ROBECO Funds has marketing approval for the funds listed on this website, all of which are UCITS funds. ROBECO is authorized by the AFM and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.

Many of the protections provided by the United Kingdom regulatory framework may not apply to investments in ROBECO Funds, including access to the Financial Services Compensation Scheme and the Financial Ombudsman Service. No representation, warranty or undertaking is given as to the accuracy or completeness of the information on this website.

If you are not an institutional client or professional investor you should therefore not proceed. By proceeding please note that we will be treating you as a professional client for regulatory purposes and you agree to be bound by our terms and conditions.

If you do not accept these terms and conditions, as well as the terms of use of the website, please do not continue to use or access any pages on this website.

I Disagree