Chapter 36. Incorporating Trading Strategies in the Black-Litterman Framework

PETTER N. KOLM, PhD

Clinical Associate Professor and Deputy Director of the Mathematics in Finance MS Program, Courant Institute, New York University

SERGIO M. FOCARDI

Partner, The Intertek Group

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

Abstract: It is well known that applying classical portfolio optimization in practice may lead to problems; in fact, the "optimal" portfolio may not be optimal at all. The problems encountered in real-world portfolio optimization include issues such as unstable portfolio weights, corner solutions, and poor performance. Some portfolio managers are using Bayesian estimation techniques and robust portfolio optimization to mitigate some of these problems. The Black-Litterman framework has become more popular among practitioners as it provides a flexible yet robust quantitative portfolio management tool, into which different trading strategies are easily incorporated.

Keywords: portfolio optimization, Black-Litterman model, capital asset pricing model (CAPM), market equilibrium, momentum, trading strategies, portfolio rebalancing

The simplicity and the intuitive appeal of portfolio construction using modern portfolio theory have attracted significant attention both in academia and in practice. Yet, despite considerable effort it took many years until portfolio managers started using modern portfolio theory for managing real money. ...

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