Global Portfolio Optimization

Fischer Black and

Robert Litterman

Quantitativeasset allocation models have not

played the importantrole
theyshould in global portfolio management.A good
part of theproblem is that
such models are difficultto
use and tend to resultin
portfoliosthat are badly
behaved.

cn

Considerationof theglobal
CAPMequilibriumcan significantlyimprovethe usefulness of thesemodels.In
particular,equilibriumreturnsfor equities,bonds
and currenciesprovide
neutral startingpointsfor
estimatingthe set of expected excessreturns
needed to drive theportfolio optimizationprocess.
Thisset of neutral weights
can then be tilted in accordance with the investor's
views.

LU

LU

LU

z
D

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z
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28

If the investorhas no particular viewsabout asset

returns,he can use the
neutral valuesgiven by the
equilibriummodel. If the
investordoes have one or
more viewsabout the relativeperformancesof assets,
or theirabsoluteperformances, he can adjust
equilibriumvalues in accordance with those views.
Furthernore,the investor
can control how strongly a

particular view influences

portfolio weights,in accordance with the degree of
confidence with whichhe
holds the view.
Investorswithglobalportfoliosof
equities and bonds are generally
aware that their asset allocation
decisions-the proportions of
funds they invest in the asset
classes of differentcountriesand
the degrees of currency hedging-are the most importantinvestmentdecisions they make.In
deciding on the appropriateallocation, they are usuallycomfortable making the simplifyingassumptionthattheirobjectiveis to
maximize expected return for a
given level of risk (subject, in
most cases, to various types of
constraints).

These unreasonableresults stem

from two well recognized problems. First,expected returnsare
very difficultto estimate. Investorstypicallyhaveknowledgeable
views about absolute or relative
returnsin only a few markets.A
standard optimization model,
however, requires them to provide expected returnsfor all assets and currencies.Thus investors must augment their views
with a set of auxiliaryassumptions, and the historicalreturns
they often use for this purpose
providepoor guides to futurereturns.

Second, the optimalportfolioasset weights and currency positions of standardasset allocation

models are extremelysensitiveto
the returnassumptionsused. The
two problems compound each
other;the standardmodel has no
way to distinguishstronglyheld
views fromauxiliaryassumptions,
mathe- and the optimalportfolioit genGiventhe straightforward
maticsof this optimizationprob- erates,given its sensitivityto the
lem, the many correlations expected returns, often appears
among global asset classes re- to bear little or no relationto the
quiredin measuringrisk,and the views the investorwishes to exlargeamountsof moneyinvolved, press. In practice,therefore,deone might expect that,in today's spite the obvious conceptual
computerizedworld, quantitative attractionsof a quantitativeapmodels would play a dominant proach, few global investment
role in the global allocationpro- managersregularlyallow quanticess. Unfortunately,when inves- tativemodels to playa majorrole
tors have tried to use quantitative in theirassetallocationdecisions.
models to help optimizethe critical allocation decision, the un- This article describes an apreasonablenature of the results proach that providesan intuitive
has often thwartedtheir efforts.' solutionto the two problemsthat
When investors impose no con- have plagued quantitativeasset
straints,the models almostalways allocation models. The key is
ordain large short positions in combiningtwo establishedtenets
many assets. When constraints of modern portfoliotheory-the
rule out shortpositions,the mod- mean-variance optimization
els often prescribe"corner"solu- frameworkof Markowitzand the
tions with zero weights in many capital asset pricing model
assets, as well as unreasonably (CAPM)of Sharpe and Lintner.2
largeweightsin the assetsof markets with small capitalizations. Copyright 1991 by Goldman Sachs.

The CFA Institute

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Financial Analysts Journal

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Glossary
*"AssetExcess Returns:

*'Risk Premiums:
Means implied by the equilibrium model.

In this article, returns on assets less the domestic short rate

(see formulas in footnote 5).

loBalance:

A measure of how close a

portfolio is to the equilibrium
portfolio.

*Bencbmark Portfolio:
The standard used to define
the risk of other portfolios. If
a benchmark is defined, the
risk of a portfolio is measured
as the volatility of the tracking
error-the difference between
the portfolio's rerturns and
those of the benchmark.

* Currency Excess Returns:

Returns on forward contracts
(see formulas in footnote 5).

l-Expected Excess Returns:

Expected values of the distribution of future excess returns.

*Equilibrium:
The condition in which means
(see below) equilibrate the
demand for assets with the
outstanding supply.

loEquilibrium Portfolio:

The portfolio held in equilibrium; in this article, market

capitalization weights, 80%
currency hedged.

*Means:
Expected excess returns.

*Neutral Portfolio:
An optimal portfolio given
neutral views.

NoNeutral Views:
Means when the investor has
no views.

*Normal Portfolio:
The portfolio that an investor
feels comfortable with when
he has no views. He can use
the normal portfolio to infer a
benchmark when no explicit
benchmark exists.

Our approach allows the investor

to combine his views about the
outlook for global equities, bonds
and currencies with the risk premiums generated by Black'sglobal version of CAPM equilibrium.3 These equilibrium risk
premiums are the excess returns that equate the supply and
demand for global assets and currencies.
As we have noted, and will illustrate,the mean-varianceoptimization used in standardasset allocation models is extremely sensitive
to the expected return assumptions the investor must provide.
In our model, equilibrium risk
premiums provide a neutral reference point for expected returns. This, in turn, allows the
model to generate optimal portfolios that are much better behaved than the unreasonable
portfolios that standard models
typically produce, which often include large long and short positions unless otherwise constrained. Instead, our model
gravitates toward a balanced-i.e.,
market-capitalization-weightedportfolio that tilts in the direction
of assets favored by the investor.
Our model does not assume that
the world is always at CAPMequilibrium, but rather that when expected returns move away from
their equilibrium values, imbalances in marketswill tend to push
them back. We thus think it is
reasonable to assume that expected returns are not likely to
deviate too far from equilibrium
values. This suggests that the investor may profit by combining
his views about returns in different markets with the information
contained in equilibrium prices
and returns.

drive optimization analysis. Equilibrium risk premiums provide a

center of gravity for expected returns. The expected returns used
in our optimization will deviate
from equilibrium risk premiums
in accordance with the investor's
explicitly stated views. The extent
of the deviations from equilibrium will depend on the degree
of confidence the investor has in
each view. Our model makes adjustments in a manner as consistent as possible with historical
covariances of returns of different
assets and currencies.
Our use of equilibrium allows
investors to specify views in a
much more flexible and powerful
way than is otherwise possible.
For example, rather than requiring the investor to have a view
about the absolute return on every asset and currency, our approach allows the investor to
specify as many or as few views as
he wishes. In addition, the investor can specify views about relative returns and can specify a
degree of confidence about each
view.

A set of examples illustrates how

the incorporation of equilibrium
into the standard asset allocation
model makes it better behaved
and enables it to generate insights
for the global investment manager. To that end, we start with a
discussion of how equilibrium
0
can help an investor translate his rn
views into a set of expected re- 0
turns for all assets and currencies. co
We then follow with a set of ap- uJ
plications of the model that illus- H
trate how the equilibrium solves 2VIlU
the problems that have tradition- z
ally led to unreasonable results in D
0
standard mean-variance models.
w

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Neutral Views

Why should an investor use a

global equilibrium model to help -j
make his global asset allocation
decision? A neutral reference is a
Our approach distinguishes be- critically important input in mak- z
twveenthe views of the investor ing use of a mean-variance optiand the expected returns that mization model, and an equilib- 29
z

u
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Table I Historical Excess Returns, January 1975-August 1991*

Germany

France

Japan

UK

US.

Canada

Australia

Currencies
Bonds
Equities

-20.8
15.3
112.9

Total Mean Excess Return

3.2
23.3
13.4
-2.3
42.3
21.4
-4.9
117.0
223.0 291.3 130.1

12.6
-22.8
16.7

3.0
-13.1
107.8

Currencies
Bonds
Equities

-1.4
0.9
4.7

Annualized Mean Excess Return

0.2
0.8
1.3
2.1
-0.1
1.2
-0.3
4.8
8.6
7.3
5.2

0.7
-1.5
0.9

0.2
-0.8
4.5

tions that bear no obvious relation to the expected excess return

assumptions. When we constrain
shorting,we have positive weights
in only two of the 14 potential
assets. These portfolios are typical
of those generated by standard
optimization models.

The use of past excess returns to

represent a "neutral"set of views
is equivalent to assuming that the
Annualized Standard Deviation
constant portfolio weights that
12.1
Currencies
11.7
12.3
11.9
4.7
10.3
would have performed best hisBonds
6.8
7.8
4.5
4.5
6.5
9.9
5.5
torically are in some sense neu22.2
Equities
18.3
17.8
24.7
16.1
18.3
21.9
tral. In reality, of course, they are
* Bondandequityreturnsin U.S.dollars,currencyhedgedandin excessof the Londoninterbank not neutral at all, but rather are a
very special set of weights that go
offeredrate(LIBOR);
returnson currenciesare in excess of the one-monthforwardrates.
short assets that have done poorly
and go long assets that have done
in the particular historical
well
rium provides the appropriate Of course, besides equilibrium
period.
neutral reference. Most of the risk premiums, there are several
time investors have viewsother naive approaches investors
Equal Means
feelings that some assets or cur- might use to construct an optimal
The
investor
might hope that asrencies are overvalued or under- portfolio when they have no
means for returns
suming
equal
valued at current market prices. views about assets or currencies.
all
across
countries
for each asset
An asset allocation model can We examine some of these-the
in
class
would
result
an approprihelp them to apply those views to historical average approach, the
their advantage. But it is unrealis- equal mean approach and the ate neutral reference. Table IV
tic to expect an investor to be risk-adjusted equal mean ap- gives an example of the optimal
portfolio for this type of analysis.
able to state exact expected ex- proach-below.
we get an unreasonable
Again,
cess returns for every asset and
portfolio.7
Historical Averages
currency. The equilibrium, however, can provide the investor an The historical average approach Of course, one problem with this
appropriate point of reference.
assumes, as a neutral reference, approach is that equal expected
that excess returns will equal excess returns do not compenSuppose, for example, that an in- their historical averages. The sate investors appropriately for
vestor has no views. How then, problem with this approach is the different levels of risk in ascan he define his optimal portfo- that historical means provide very sets of different countries. Inveslio? Answering this question dem- poor forecasts of future returns. tors diversify globally to reduce
on
onstrates the usefulness of the For example, Table I shows many risk. Everythingelse being equal,
negative values. Table III shows they prefer assets whose returns
equilibrium risk premium.
what happens when we use such are less volatile and less corre0
U In considering this question, and returns as expected excess return lated with those of other assets.
others throughout this article, we assumptions. We may optimize
use historical data on global eq- expected returns for each level of Although such preferences are
uities, bonds and currencies. We risk to get a frontier of optimal obvious, it is perhaps surprising
use a seven-country model with portfolios. The table illustrates how unbalanced the optimal
cca
monthly returns for the United the frontiers with the portfolios portfolio weights can be, as Table
States, Japan, Germany, France, that have 10.7% risk, with and IV illustrates, when we take "everything else being equal" to
the United Kingdom, Canada and without shorting constraints.6
such a literal extreme. With no
Australia from January 1975
We can make a number of points constraints, the largest position is
through August 1991.4
about these "optimal" portfolios. short Australianbonds.
z
Table I presents the means and First,they illustratewhat we mean
Risk-Adjusted Equal Means
standard deviations of excess re- when we claim that standard
30
turns and Table II the correla- mean-varianceoptimization mod- Our third naive approach to detions. All the results in this article els often generate unreasonable fining a neutral reference point is
are given from a U.S. dollar per- portfolios. The portfolio that does to assume that bonds and equities
spective; use of other currencies not constrain against shorting has have the same expected excess
would give similar results.5
many large long and short posi- return per unit of risk, where the
cn

LL

Table II Historical Correlations of Excess Returns, January 1975-August 1991

Germany
Equities

France

Bonds

Currency

Equities

Bonds

Japan
Currency

Equities

Bonds

Currency

Germany
Equities
Bonds
Currency

1.00
0.28
0.02

1.00
0.36

1.00

France
Equities
Bonds
Currency

0.52
0.23
0.03

0.17
0.46
0.33

0.03
0.15
0.92

1.00
0.36
0.08

1.00
0.15

1.00

Japan
Equities
Bonds
Currency

0.37
0.10
0.01

0.15
0.48
0.21

0.05
0.27
0.62

0.42
0.11
0.10

0.23
0.31
0.19

0.04
0.21
0.62

1.00
0.35
0.18

1.00
0.45

1.00

UK
Equities
Bonds
Currency

0.42
0.14
0.02

0.20
0.36
0.22

-0.01
0.09
0.66

0.50
0.20
0.05

0.21
0.31
0.05

0.04
0.09
0.66

0.37
0.20
0.06

0.09
0.33
0.24

0.04
0.19
0.54

Equities
Bonds

0.43
0.17

0.23
0.50

0.03
0.26

0.52
0.10

0.21
0.33

0.06
0.22

0.41
0.11

0.12
0.28

-0.02
0.18

Canada
Equities
Bonds
Currency

0.33
0.13
0.05

0.16
0.49
0.14

0.05
0.24
0.11

0.48
0.10
0.10

0.04
0.35
0.04

0.09
0.21
0.10

0.33
0.14
0.12

0.02
0.33
0.05

0.04
0.22
0.06

Australia
Equities
Bonds
Currency

0.34
0.24
-0.01

0.07
0.19
0.05

-0.00
0.09
0.25

0.39
0.04
0.07

0.07
0.16
-0.03

0.05
0.08
0.29

0.25
0.12
0.05

-0.02
0.16
0.10

0.12
0.09
0.27

Us

United States

United Kingdom

Bonds

Canada
Bonds

Australia

Equities

Bonds

1.00
0.47
0.06

1.00
0.27

1.00

Equities
Bonds

0.58
0.12

0.23
0.28

-0.02
0.18

1.00
0.32

1.00

Canada
Equities
Bonds
Currency

0.56
0.18
0.14

0.27
0.40
0.13

0.11
0.25
0.09

0.74
0.31
0.24

0.18
0.82
0.15

1.00
0.23
0.32

1.00
0.24

1.00

Australia
Equities
Bonds
Currency

0.50
0.17
0.06

0.20
0.17
0.05

0.15
0.09
0.27

0.48
0.24
0.07

-0.05
0.20
-0.00

0.61
0.21
0.19

0.02
0.18
0.04

0.18
0.13
0.28

UK
Equities
Bonds
Currency

Currency

Equities

Equities

Currency

Equities

Bonds

US.
an

LU

U
LU

1.00
0.37
0.27

1.00
0.20

LU

4:

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risk measure is simply the volatility of asset returns. Currencies in

this case are assumed to have no
excess return. Table V shows the
optimal portfolio for this case.

is no better. One problem with

this approach is that it hasn't
taken the correlations of the asset
returns into account. But there is
another problem as well-perNow we have incorporated vola- haps more subtle, but also more
tilities, but the portfolio behavior serious.

This approach, and the others we z

have so far used, are based on
what might be called the "demand for assets" side of the equa- 4:
z
tion-that is, historical returns
and risk measures. The problem
with such approaches is obvious 31

Table III Optimal Portfolios Based on Historical Average Approach The equilibrium degree of hedging-the "universalhedging conGermany France Japan UK
US. Canada Australia stant"-depends on three averages-the averageacross countries
Unconstrained
of the mean return on the market
Currency
-78.7
46.5
28.6
15.5
65.0
-5.2
portfolio of assets, the average
Exposure (%)
across countries of the volatility
Bonds (%)
30.4
-40.7
40.4 -1.4 54.5 -95.7
-52.5
of the world market portfolio,
Equities (%)
4.4
-4.4
44.0
-44.2
15.5
13.3
9.0
and the average across all pairs of
countries
of exchange rate volatilWith Constraints Against Shorting Assets
ity.
-160.0
Currency
18.0
115.2
23.7
77.8
-13.8
Exposure (%)
Bonds (%)
Equities (%)

7.6
0.0

0.0
0.0

88.8
0.0

0.0
0.0

0.0
0.0

0.0
0.0

0.0
0.0

when we bring in the supply side

of the market.

It is difficult to pin down exactly

the right value for the universal
hedging constant, primarily because the risk premium on the
market portfolio is a difficult
number to estimate. Nevertheless, we feel that universal hedging values between 75% and 85%
are reasonable. In our monthly
data set, the former value corresponds to a risk premium of 5.9%
on U.S. equities, while the latter
corresponds to a risk premium of
9.8%. For this article, we will use

rency risk up to the point where

the additional risk balances the
expected return. Under certain
Suppose the market portfolio simplifying assumptions, the percomprises two assets, with centage of foreign currency risk
weights 80% and 20%.In a simple hedged will be the same for inworld, with identical investors all vestors of different countriesholding the same views and both giving rise to the name "universal
assets having equal volatilities, ev- hedging" for this equilibrium.
eryone cannot hold equal weights
of each asset. Prices and expected
excess returns in such a world
would have to adjustas the excess Table IV Optimal Portfolios Based on Equal Means
demand for one asset and excess
supply of the other affectthe marGermany France Japan
UK
US. Canada Australia
ket.

The Equilibrium Approach

ra

on
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32

32

To us, the only sensible definition

of neutral means is the set of
expected returns that would
"clear the market" if all investors
had identical views. The concept
of equilibrium in the context of a
global portfolio of equities,
bonds and currencies is similar,
although currencies do raise a
complicating question. How
much currency hedging takes
place in equilibrium? The answer
is that, in a global equilibrium,
investors worldwide will all want
to take a small amount of currency risk.8

Currency
Exposure (%)
Bonds (%)
Equities (%)

Currency
Exposure (%)
Bonds (%)
Equities (%)

14.5
-11.6
21.4

Unconstrained
-12.6
-0.9
4.2
-4.8

-1.8
23.0

4.4
-10.8
-4.6

13.9
32.2

-18.7

-2.1

-18.9
9.6

-32.7
10.5

With Constraints Against Shorting Assets

-11.2
14.3
0.2
-4.5
-25.9
0.0
17.5

0.0
0.0

0.0
22.1

0.0 0.0
0.0 27.0

0.0
8.2

-2.0
0.0
7.3

Table V Optimal Portfolios Based on Equal Risk-AdjustedMeans

Germany France Japan
Currency
Exposure (%)
Bonds (%)
Equities (%)

5.6

UK

Unconstrained
11.3 -28.6 -20.3

US.

Canada Australia
-50.9

This result arises because of a

12.6
54.0
-23.9
20.8
23.1
37.8
curiosity known in the currency
12.4 -0.3 -14.1
9.9
8.5
13.2
world as "Siegel's paradox." The
basic idea is that, because invesWith Constraints Against Shorting Assets
tors in different countries mea21.7
-14.0 -12.2
Currency
-8.9
-47.9
sure returns in different units,
Exposure (%)
each will gain some expected re- Bonds (%)
0.0
0.0
0.0
7.8
0.0
19.3
turn by taking some currency Equities (%)
11.1
9.4
6.0
0.0
7.6
19.2
risk. Investors will accept cur-

-4.9
15.6
20.1

-6.7
0.0
19.5

Table VI Equilibrium Risk Premiums (% annualized excess returns)

Germany France Japan
Currencies
Bonds
Equities

1.01
2.29
6.27

1.10
2.23
8.48

1.40
2.88
8.72

UK
0.91
3.28
10.27

US.

Canada

Australia

1.87
7.32

0.60
2.54
7.28

0.63
1.74
6.45

an equilibriumvaluefor currency
hedging of 80%. Table VI gives
the equilibrium risk premiums
for all assets, given this value of
the universalhedging constant.9

between investor views on the

one hand and a complete set of
expected excess returns for all
assets on the other-is not usually recognized.In our approach,
views represent the subjective
Considerwhathappenswhen we feelings of the investoraboutreladopt these equilibriumrisk pre- ative values offered in different
miums as our neutral means markets.10
If an investordoes not
when we haveno views.TableVII havea view abouta given market,
shows the optimalportfolio.It is he should not have to state one.
simply the market-capitalizationAndif some of his views are more
portfolio with 80% of the cur- strongly held than others, he
rency risk hedged. Other portfo- should be able to express the
lios on the frontierwith different differences.
levels of risk would correspond
to combinationsof risk-freebor- Mostviews are relative.Forexamrowing or lending plus more or ple, the investor may feel one
less of this portfolio.
marketwill outperformanother.
Or he may feel bullish (above
By itself,the equilibriumconcept neutral) or bearish (below neuis interestingbut not particularly tral) about a market.As we will
useful.Its real value is to provide show, the equilibriumallows the
a neutralframeworkthe investor investorto express his views this
can adjustaccordingto his own way, instead of as a set of exviews, optimization objectives pected excess returns.
and constraints.

To see why this is so important,

we start by illustratingthe extreme sensitivity of portfolio
weights to the expected excess
returnsand the inabilityof investors to expressviews directlyas a
completeset of expectedreturns.
We have alreadyseen how difficult it can be simply to translate
no views into a set of expected
excess returnsthatwill not lead
an asset allocationmodel to produce an unreasonableportfolio.
But suppose thatthe investorhas
alreadysolved that problem, using equilibriumriskpremiumsas
the neutralmeans.He is comfortable with a portfoliothathas market capitalizationweights, 80%
hedged. Considerwhat can happen when this investornow tries
to express one simple, extremely
modest view.
Suppose the investor's view is
that,over the next three months,
the economic recovery in the
United States will be weak and
bondswill performrelativelywell
and equities poorly. The investor'sview is not very strong,and
he quantifiesit by assumingthat,
over the next three months, the
U.S. benchmarkbond yield will
drop 1 basispointratherthanrise

Table VII Equilibrium Optimal Portfolio

Expressing Views
Investorstrying to use quantitaGermany France Japan UK
US. Canada
tive asset allocationmodels must
1.1
2.0
0.9
5.9
0.6
translatetheir views into a com- Currency
Exposure (%)
plete set of expected excess re- Bonds
(%)
2.9
1.9
6.0
1.8 16.3
1.4
turnson assetsthatcanbe used as Equities (%)
2.4
2.6
23.7
8.3 29.7
1.6
a basis for portfoliooptimization.
As we will show here, the problem is that optimal portfolio
weights from a mean-variance Table VIII Optimal Portfolios Based on a Moderate View
model are incrediblysensitiveto
minor changes in expected exGermany France Japan UK
US. Canada
cess returns. The advantageof
incorporating a global equilibUnconstrained
riumwill become apparentwhen Currency
-6.4
-1.3
8.3
-3.3
8.5
Exposure (%)
we show how to combine it with
6.4
-13.6
15.0 -3.3
112.9 -42.4
an investor's views to generate Bonds (%)
(%)
Equities
3.7
6.3
27.2
14.5
24.8
-30.6
well-behavedportfolios,without
requiringthe investorto express
With Constraints Against Shorting Assets
a completeset of expectedexcess
9.2
2.3
4.3
5.0 -3.0
Currency
returns.
Exposure (%)

We should emphasize that the

distinction we are making

Bonds (%)
Equities (%)

0.0
2.6

0.0
5.3

0.0
28.3

0.0
13.6

35.7
0.0

0.0
13.1

Australia
0.3
0.3
1.1

r'i
0)
0a

oL
LU

m
LU
L1J

Australia

D
z

-1.9
0.7
6.0

-0.6

-J

z
z

0.0
1.5

33

1 basis point, as is consistent with

the equilibrium risk premium.11
Similarly, the investor expects
U.S. share prices to rise only 2.7%
over the next three months,
rather than to rise the 3.3% consistent with the equilibrium view.
To implement the asset allocation
optimization, the investor starts
with expected excess returns
equal to the equilibrium risk premiums and adjusts them as follows. He moves the annualized
expected excess returns on U.S.
bonds up by 0.8 percentage
points and the expected excess
returns on U.S. equities down by
2.5 percentage points. All other
expected excess returns remain
unchanged. Table VIII shows the
optimal portfolio, given this view.

2. We assume that both

sources of informationare
uncertainand are best expressedas probabilitydistributions.
3. We choose expected excess
returnsthatare as consistent
as possible with both
sources of information.
The above description captures
the basic idea, but the implementationof the approachcan lead to
some novel insights.We will now
show how a relativeview about
two assets can influence the expected excess return on a third
asset.12

Three-Asset Example
Let us first work through a very

simple exampleof our approach.

Afterthis illustration,we will apply it in the contextof our sevencountry model. Suppose we
know the true structure of a
world thathas justthree assets,A,
B and C. The excess return for
each of these assets is known to
be generated by an equilibrium
risk premium plus four sources
of risk-a common factor and
independent shocks to each of
the three assets.We can express
this model as follows:

Note the remarkable effect of this

very modest change in expected
excess returns. The portfolio
weights change in dramatic and
largely inexplicable ways. The optimal portfolio weights do shift
out of U.S. equity into U.S. bonds,
as might be expected, but the
model also suggests shorting Canadian and German bonds. The
lack of apparent connection between the view the investor is
attempting to express and the optimal portfolio the model gener- RA = 'TA + YAZ + VA)
ates is a pervasive problem with
standardmean-varianceoptimization. It arises because there is a RB = 7rB + YBZ + VB,
complex interaction between expected excess returns and the vol- RC= 'TC+ YCZ+ VC,
atilities and correlations used in
where:
measuring risk.
UJ
0
R, = the excess return on the
Combining Investor
LU

are a function of the equilibrium

risk premiums, the expected value
of the common factor, and the
expected values of the independent shocks to each asset. For
example, the expected excess return of asset A, which we write as
E[RA],is given by:
E[RA]=

7TA +

yAE[Z]+ E[vj.

We are not assuming that the

world is in equilibrium (i.e., that
E[Z] and the E[vi]s are equal to
zero). We do assume that the
mean, E[RA],is itself an unobservable random variable whose
distribution is centered at the
equilibrium risk premium. Our
uncertainty about E[RA]is due to
our uncertainty about E[Z] and
the E[vi]s. Furthermore, we assume the degree of uncertainty
about E[Z] and the E[vi]s is proportional to the volatilities of Z
and the vis themselves.
This implies that E[RA]is distributed with a covariance structure
proportional to E. We will refer
to this covariance matrix of the
expected excess returns as rY.
Because the uncertainty in the
mean is much smaller than the
uncertainty in the return itself, r
will be close to zero. The equilibrium risk premiums together
with rX determine the equilibrium distribution for expected
excess returns. We assume this
information is known to all; it is
not a function of the circumstances of any individual investor.

In addition, we assume that each

investor provides additional inViews with Market
,wi = the equilibrium risk pre- formation about expected excess
Equilibrium
returns in the form of views. For
mium on the ith asset,
example, one type of view is a
How our approach translates a
yi = the impact on the ith as- statement of the form: "I expect
few views into expected excess
z
set of Z,
asset A to outperform asset B by
returns for all assets is one of its
cc
=
Z
the common factor, and Q,"where Q is a given value.
more complex features, but also
vi = the independent shock
one of its most innovative. Here is
to the ith asset.
We interpret such a view to mean
the intuition behind our apthat the investor has subjective
z
proach.
In this world, the covariancema- information about the future re1. We believe there are two trix, E, of asset excess returnsis turns of A relative to B. One way
U
z
distinct sources of informa- determined by the relative im- we think about representing that
z
tion about future excess re- pacts of the common factorand information is to act as if we had a
turns-investor views and the independentshocks.The ex- summary statistic from a sample
market equilibrium.
pectedexcess returnsof the assets of data drawn from the distribu34
LU

-J

ith asset,

TableIX ExpectedExcessAnnualizedPercentageReturnsCombin- In the more general case where

ing InvestorViews With Equilibrium
we are not 100%confident,we
can thinkof a view as representUS
Germany
France
UK
ing a fixed number of observaJapan
Canada
Australia
tions drawnfrom the distribution
Currencies
1.28
1.22
0.44
1.32
1.73
0.47
of futurereturns.In this case, we
Bonds
2.69
3.40
2.39
3.29
2.70
2.39
1.35
Equities
6.42
5.28
7.71
7.83
4.39
3.86
4.58
follow the "mixed estimation"
strategydescribed in Theil.14Alternatively,we can think of the
view as directlyreflectinga subjective distribution for the extion of future returns, data in the means of the random compo- pected excess returns. In this
whichallwe were able to observe nents.
case, we use the Black-Litterman
approach, given in the appenis the differencebetween the returnsof A and B. Alternatively,
we We have the equilibrium distribu- dix.15 The formula for the excan express the view directlyas a tion for E[R],which is given by pected excess returns vector is
probability distribution for the Normal (w, rY,),where w = {WTA, the same fromeitherperspective.
differencebetween the means of 7B' 7r} We wish to calculate a
the excess returnsof A and B. It conditional distribution for the In either approach,we assume
doesn'tmatterwhich of these ap- expected returns, subject to the thatthe view can be summarized
proaches we use to think about restriction that the expected re- by a statement of the form
our views;in the end we get the turns satisfy the linear restriction P*E[RI'= Q + s,where PandQ
same result.
E[RA1- E[RB]= Q. We can write are given and e is an unobservthis restriction as a linear equa- able, normally distributed ranIn both approaches,though, we tion in the expected returns:13
dom variablewith mean 0 and
need a measureof the investor's
variancefl. fl representsthe unconfidence in his views. We use P *E[R]' = Q,
certaintyin the view. In the limit,
this measure to determine how
as Q goes to zero, the resulting
much weight to give to the view where P is the vector [1, -1, 0O. mean converges to the condiwhen combiningit with the equitionalmean describedabove.
librium.We can thinkof this de- The conditional normal distribugree of confidence as determin- tion has the following mean:
When there is more than one
ing, in the first case, the number
view, the vector of views can be
of observationsthatwe havefrom 77" + Ty,.p, .[P - T .pt]- I
representedby P *E[R]'= Q + ,
the distributionof futurereturns
where we now interpretP as a
or as determining,in the second,
matrix,and e is a normallydis-[
I
P -1 V,
+Q
the standard deviation of the
tributed random vector with
probabilitydistribution.
mean 0 and diagonalcovariance
which is the solution to the prob- matrix fQ. A diagonal fl correIn our example,considerthe lim- lem of minimizing
spondsto the assumptionthatthe
iting case: The investor is 100%
views represent independent
sure of his view. We might think (E[R]- )T
draws from the future distribu1(E[R]- 7)
of this as the case where we have
tion of returns,or thatthe deviaan unboundednumberof obser- subject to P *E[R]I= Q.
tions of expected returns from ,0
vations from the distributionof
the meansof the distributionrepfuturereturns,and where the av- For the special case of 100%con- resentingeach view are indepen- UJ
erage value of RA- RBfrom these fidence in a view, we use this dent, depending on which ap- UJ
datais Q. In this special case, we conditional mean as our vector of proach is used to think about LU
can representthe view as a linear expected excess returns.
subjective views. The appendix H
restriction on the expected excess returns-i.e., E[RA]- E[RBI

= Q.

In this special case, we can compute the distributionof E[R] =

Table X

Optimal Portfolio Combining Investor Views With

Equilibrium

-J

{E[R,j, E[RB], E[RJ} conditional

on the equilibriumand this information. This is a relatively

straightforward problem from
multivariatestatistics.To simplify,
assume a normaldistributionfor

Currency
Exposure (%)
Bonds (%)
Equities (%)

Germany
1.4

France
1.1

Japan
7.4

UK
2.5

US.

Canada
0.8

Australia
0.3

3.6
3.3

2.4
2.9

7.5
29.5

2.3
10.3

67.0
3.3

1.7
2.0

0.3
1.4

z
z

35

Table XI

Economists' Views
France

Japan

UK

1.743

5.928

137.3

1.688

1.790

6.050

141.0

1.640

Germany
Currencies
July 31, 1991
Current Spot Rates
Three-Month Horizon
Expected Future Spot
Annualized Expected
Excess Returns
Interest Rates
July 31, 1991
Benchmark Bond Yields
Three-Month Horizon
Expected Future Yields
Annualized Expected
Excess Returns

-7.48

-4.61

-8.85

-6.16

8.7

9.3

6.6

10.2

8.8

9.5

6.5

10.1

-3.31

-5.31

1.78

1.66

gives the formula for the expected excess returns that combine views with equilibrium in
the general case.

exceeds that of B by more than it

does in equilibrium. From this,
we clearly ought to impute that a
shock to the common factor is the
most likely reason A will outperNow consider our example, in form B. If so, C ought to perform
which asset correlations result better than equilibrium as well.
from the impact of one common The conditional mean in this case
factor. In general, we will not is [3.9, 1.9, 2.9]. Indeed, the invesknow the impacts of the factor on tor's view of A relative to B has
the assets-that is, the values of raised the expected return on C
yA, yB and yYcBut suppose the by 1.9 percentage points.
unknown values are [3, 1, 2]. Suppose further that the independent But now suppose the indepenshocks are small, so that the assets dent shocks have a much larger
are highly correlated with volatil- impact than the common factor.
ities approximately in the ratios Let the I matrix be as follows:
3:1:2.

(r

0)
LU

Suppose, for example, the covariance matrix is as follows:

[9.13.0

19.0
3.0

3.0
11.0

6.0
2.0

6.0

2.0

14.0]

US

1.000

Canada

Australia

1.151

1.285

1.156

1.324

0.77

-8.14

8.2

9.9

11.0

8.4

10.1

10.8

-3.03

-3.48

5.68

own independent shock. Although we should impute some

change in the factor from the
higher return of A relative to B,
the impact on C should be less
than in the previous case.
In this case, the conditional mean
is [2.3, 0.3, 1.3]. Here the implied
effect of the common-factor shock
on asset C is lower than in the
previous case. We may attribute
most of the outperformance of A
relative to B to the independent
shocks; indeed, the implication
for E[RB]is negative relative to
equilibrium. The impact of the
independent shock to B is expected to dominate, even though
the contribution of the common
factor to asset B is positive.

Note that we can identify the impact of the common factor only if
0
3.0 1.1 2.0
we assume that we know the true
6.0 2.0 4.1
structure that generated the cova0~
riance matrix of returns. That is
true here, but it will not be true in
Assume also, for simplicity, that
the percentage equilibrium risk This time, more than half of the general. The computation of the
premiums are equal-for exam- volatilityof A is associated with its conditional mean, however, does
z
ple, [1, 1, 1]. There is a set of
VI
D
::
market capitalizations for which
-J
that is the case.
r-J
Table XII Optimal (Unconstrained) Portfolio Based on Economists'
Views
U
z
Now consider what happens
when the investor expects A to
Germany France Japan
UK
US Canada Australia
:
outperform B by 2%. In this ex68.8
-12.7
Currency
16.3
-35.2
29.7
-51.4
Z ample, virtuallyall of the volatility
Exposure (%)
z
of the assets is associated with Bonds (%)
34.5
-65.4
79.2
16.9
3.3
-22.7
108.3
movements in the common fac- Equities (%)
-2.2
6.6
3.6
0.6
0.7
5.2
0.5
36 tor, and the expected return of A

LU
m

LU

6.0

Suppose the equilibrium risk premiums are again given by [1, 1, 1].
Now assume the investor expects
that A will outperform B by 2%.

Table XIII Optimal Portfolio With Less Confidence in the Economists' Views
Germany
Currency
Exposure (%)
Bonds (%)
Equities (%)

-12.9
-3.9
0.8

France

Japan

UK

-3.5

-10.0

-6.9

-21.0
2.2

19.6
24.7

2.6
7.1

US.

7.3
26.6

Canada

Australia

-0.4

-17.9

-13.6
4.2

42.4
1.2

not depend on this special knowl- only the returnsto U.S.bonds and
edge, but only on the covariance U.S. equities, holding fixed all
other expected excess returns.
matrix of returns.
Finally, let's look at the case
where the investor has less confidence in his view. We might say
(E[RA]- E[RB])has a mean of 2
and a variance of 1, and the covariance matrix of returns is, as it
was originally:

Anotherdifferenceis thathere we
specify a differentialof means,
lettingthe equilibriumdetermine
the actuallevels of means;above
we had to specify the levels directly.

TableIX shows the complete set

of expected excess returnswhen
we
put 100%confidencein a view
[9.1 3.0 6.0
that
the differentialof expected
1.1
2.0
3.0
excess returns of U.S. equities
4.1]
2.0
6.0
over bondswill be 2.0 percentage
pointsbelow the equilibriumdifIn this example, however, the ferentialof 5.5 percentagepoints.
conditional mean is based on an Table X shows the optimalportuncertain view. Using the formula folio associatedwith this view.
given in the appendix, we find
that the conditional mean is given
by:
[3.3, 1.7, 2.5].
Because the investor has less confidence in his view, the expected
relative return of 2%for A - B is
reduced to a value of 1.6, which is
closer to the equilibrium value of
0. There will also be a smaller
effect of the common factor on
the third asset because of the
uncertainty of the view.

Seven-Country Example

tion we focus more specifically

on the concept of a "balanced"
portfolioand show an additional
featureof our approach:Changes
in the "confidence"in views can
be used to controlthe balanceof
the optimalportfolio.
We startby illustratingwhat happens when we put a set of stronger views, shown in TableXI,into
our model. These happento have
been the short-terminterestrate
and exchange rate views expressed by GoldmanSachseconomistson July31, 1991.16 We put
100%confidence in these views,
solve for the expected excess returns on all assets, and find the
optimalportfolio,shown in Table
XII. Given such strong views on
so many assets, and optimizing
without constraints,we generate
a ratherextreme portfolio.

Analystshave tried a number of

approaches to ameliorate this
problem. Some put constraints
on manyof the assetweights.We
resist using such artificialconstraints.When asset weights run
up againstconstraints,the portfoThese results contrast with the lio optimizationno longer balinexplicableresults we saw ear- ances return and risk across all
lier.We see here a balancedport- assets.
folio in which the weights have
tilted away from marketcapitali- Others specify a benchmark
zations toward U.S. bonds and portfolio and limit the risk relaawayfrom U.S.equities.We now tive to the benchmarkuntila reaobtain a portfolio that we con- sonablybalancedportfoliois obsider reasonable,given our view. tained. This makes sense if the
objectiveof the optimizationis to
Controlling the Balance managethe portfoliorelativeto a
of a Portfolio
benchmark. We are uncomfortIn the previoussection, we illus- able when it is used simply to
tratedhow our approachallows make the model betterbehaved.
us to express a view that U.S.
bonds will outperformU.S.equi- An alternateresponse when the
ties, in a way thatleads to a well- optimal portfolio seems too exbehaved optimal portfolio that tremeis to considerreducingthe
expresses that view. In this sec- confidenceexpressedin some or

a')

co
LU

ax

H
Now we will attempt to apply our
LU
view that bad news about the U.S.
z
economy will cause U.S. bonds to
outperform U.S. stocks to the actual data. The critical difference
between our approach here and Table XIV Optimal Portfolio With Less Confidence in Certain Views
z
our earlier experiment that generated Table VIII is that here we
US. Canada Australia -J
UK
Germany France Japan
say something about expected re-7.8
-4.8
-2.8
-6.2
-10.0
-0.4
Currency
turns on U.S. bonds versus U.S.
0L
Exposure (%)
equities and we allow all other Bonds (%)
-2.4
28.1
1.6 22.9
-10.3
-34.3
25.5
expected excess returns to adjust Equities (%)
6.0
0.1
7.0 26.3
1.3
2.3
25.9
accordingly. Before we adjusted

Table XV Alternative Domestic-Weighted Benchmark Portfolio

Currency
Exposure (%)
Bonds (%)
Equities (%)

Germany
1.5

France
1.5

Japan
7.0

0.5
1.0

0.5
1.0

2.0
5.0

all of the views. Table XIII shows

the optimal portfolio that results
when we lower the confidence in
all of our views. By putting less
confidence in our views, we generate a set of expected excess
returns that more strongly reflect
equilibrium. This pulls the optimal portfolio weights toward a
more balanced position.
We define balance as a measure
of how similar a portfolio is to the

global equilibrium

portfo-

lio-that is, the market-capitalization portfolio with 80% of the

currency risk hedged. The distance measure we use is the volatility of the difference between
the returns on the two portfolios.

on

LU

Lii

cL/

H-

-J

We find this property of balance

to be a useful supplement to the
standard measures of portfolio
optimization, expected return
and risk. In our approach, for any
given level of risk there will be a
continuum of portfolios that maximize expected return depending
on the relative levels of confidence that are expressed in the
views. The less confidence the
investor has, the more balanced
his portfolio will be.
Suppose an investor does not
have equal confidence in all his
views. If the investor is willing to
rank the relative confidence levels of his different views, then he
can generate an even more powerful result. In this case, the
model will move away from his
less strongly held views more
quickly than from his more
strongly held ones.

0
z

38

We have specified higher confidence in our view of yield declines in the United Kingdom and
yield increases in France and Ger-

UK
3.0

US.

Canada
2.0

Australia
0.0

invested in the domestic shortterm interest rate. In many cases,

however, an alternative benchmark is called for.

Many portfolio managers are

given an explicit performance
benchmark, such as a marketcapitalization-weighted index. If
an explicit performance benchmany. These are not the biggest mark exists, then the appropriate
yield changes that we expect, but measure of risk for the purpose
they are the forecasts that we of portfolio optimization is the
most strongly want to represent volatility of the tracking error of
in our portfolio. We put less con- the portfolio vis-a-vis the benchfidence in our views of interest mark.And for a manager funding
rate moves in the United States a known set of liabilities, the appropriate benchmark portfolio
and Australia.
represents the liabilities.
When we put equal confidence in For many portfolio managers, the
our views, we obtained the opti- performance objective is less exmal portfolio shown in Table XIII. plicit, and the asset allocation deThe view that dominated that cision is therefore more difficult.
portfolio was the interest rate de- For example, a global equity portcline in Australia.Now, when we folio manager may feel his objecput less than 100% confidence in tive is to perform in the top rankour views, we have relatively ings of all global equity managers.
more confidence in some views Although he does not have an
than in others. Table XIV shows explicit
performance benchmark,
the optimal portfolio for this case. his risk is clearly related to the
stance of his portfolio relative to
Benchmarks
the portfolios of his competitors.
One of the most important, but
often overlooked, influences on Other examples are an overthe asset allocation decision is the funded pension plan or a univerchoice of the benchmark by sity endowment where matching
which to measure risk. In mean- the measurable liability is only a
variance optimization, the objec- small part of the total investment
tive is to maximize return per objective. In these types of situaunit of portfolio risk. The inves- tions, attempts to use quantitative
tor's benchmark defines the point approaches are often frustrated
of origin for measuring this risk. by the ambiguity of the investIn other words, it represents the ment objective.
minimum-risk portfolio.
When an explicit benchmark
In many investment problems, does not exist, two alternativeaprisk is measured as the volatility proaches can be used. The first is
of the portfolio's excess returns. to use the volatility of excess reThis is equivalent to having no turns as the measure of risk. The
benchmark, or to defining the second is to specify a "normal"
benchmark as a portfolio 100% portfolio, one that represents
1.0
2.0

30.0
55.0

1.0
1.0

0.0
0.0

Table XVI Current Portfolio Weights for Implied-View Analysis

Currency
Exposure (%)
Bonds (%)
Equities (%)

Germany

France

4.4

3.4

2.0

2.2

1.0
3.4

0.5
2.9

4.7
22.3

2.5
10.2

Japan

UK

US.

13.0
32.0

Canada

Australia

2.0

5.5

0.3
1.7

3.5
2.0

TableXVII Annualized Expected Excess Returns Implied by a views of the portfolio shown in
Table XVI,given that the benchGiven Portfolio
markis, alternatively,(1) a marportUS.
UK
Canada Australia ket-capitalization-weighted
Germany France Japan
folio, 80% hedged, or (2) the
Views Relative to the Market-Capitalization Benchmark
domestic-weighted alternative
2.45
1.22
0.63
1.82
-0.27
1.55
Currencies
shown in TableXV.Unlessa port1.22
-0.01
1.03 -0.13
-0.58
0.30
-0.30
Bonds
folio managerhas thought care5.88
5.01
6.73
4.15
3.97
-0.30
2.82
Equities
fullyaboutwhathis benchmarkis
andwhere his allocationsare relViews Relative to the Domestic-Weighted Benchmark
ativeto it, and has conductedthe
0.01
0.90
0.20
0.50 0.54
Currencies
0.05
type of analysisshown here, he
-1.01
0.18
0.21
-1.45
0.72 0.85
Bonds
-0.01
maynot have a clearidea of what
0.28
2.38
-1.49
2.83
5.24 4.83
2.24
Equities
views his portfoliorepresents.

Quantifying the Benefits

the desired allocation of assets in
the absence of views. Such a portfolio might, for example, be designed with a higher-than-market
weight for domestic assets in order to represent the domestic nature of liabilities without attempting to specify an explicit liability
benchmark.
An equilibrium model can help in
the design of a normal portfolio
by quantifying some of the risk
and return tradeoffs in the absence of views. The optimal portfolio in equilibrium is marketcapitalization-weighted and is
80% currency hedged. It has an
expected excess return (using
equilibrium risk premiums) of
5.7%and an annualized volatility
of 10.7%.
A pension fund wishing to increase the domestic weight of its
portfolio to 85%from the current
market capitalization of 45%,and
not wishing to hedge the currency risk of the remaining 15%
in international markets, might
consider an alternative portfolio
such as the one shown in Table
XV. The higher domestic weights
lead to an annualized volatility0.4
percentage points higher than
and an expected excess return 30
basis points below those of the
optimal portfolio. The pension
fund may or may not feel that its
preference for domestic concentration is worth those costs.

Implied Views
Once an investor has established
his objectives, an asset allocation

model establishes a correspon- of Global Diversification

dence betweenviews andoptimal While most investors demonportfolios.Ratherthan treatinga strate a substantialbias toward
quantitativemodel as a blackbox, domestic assets, many recent
successfulportfoliomanagersuse studieshave documenteda rapid
a model to investigatethe nature growth in the internationalcomof this relationship.In particular, ponents of portfoliosworldwide.
it is often useful to startan analy- It is perhapsnot surprising,then,
sis by using a model to find the that investment advisers have
implied investorviews for which startedto questionthe traditional
an existing portfolio is optimal argumentsthatsupportglobal direlativeto a benchmark.
versification.Thishasbeen particularly true in the United States,
For example,we assume a port- where global portfolios have
folio managerhasa portfoliowith tended to underperformdomesweights as shown in Table XVI. tic portfoliosin recentyears.
The weights, relativeto those of
his benchmark,define the direc- Of course,whatmattersfor investions of the investor'sviews. By tors is the prospective returns
assumingthe investor'sdegree of from internationalassets, and as
risk aversion, we can find the noted in our earlierdiscussionof
expected excess returns for neutral views, the historicalrewhich the portfoliois optimal.
turns are of virtuallyno value in
projectingfutureexpectedexcess
In this type of analysis,different returns.Historicalanalyses conbenchmarksmay imply very dif- tinue to be used in this context
ferentviews for a given portfolio. simplybecause investmentadvisTable XVII shows the implied ers argue there is nothingbetter

CN

a'
Lr
0a

LU

Table XVIII The Value of Global Diversification (expected excess

returns in equilibrium at a constant 10.7% risk)

LU
LU

~:
Domestic
Wlthout

Global
Currency

Basis-Point
Difference

Percentage
Gain

Hedging

Bonds Only
Equities Only
Bonds and Equities

2.14
4.72
4.76

Bonds Only
Equities Only
Bonds and Equities

With Currency Hedging

2.14
3.20
5.56
4.72
5.61
4.76

2.63
5.48
5.50

z
D

-J

49
76
74

22.9
16.1
15.5

z
-j
u
z

106
84
85

49.5
17.8
17.9

39

to measure the value of global

diversification.
We would suggest that there is
something better. A reasonable
measure of the value of global
diversification is the degree to
which allowing foreign assets into
a portfolio raises the optimal
portfolio frontier. A natural starting point for quantifying this
value is to compute it based on
the neutral views implied by a
global CAPMequilibrium.
There are some limitations to using this measure. It assumes that
there are no extra costs to international investment; thus relaxing
the constraint against international investment cannot make
the investor worse off. On the
other hand, in measuring the
value of global diversification this
way, we are also assuming that
markets are efficient and therefore we are neglecting to capture
any value that an international
portfolio manager might add
through having informed views
about these markets. We suspect
that an important benefit of international investment that we are
missing here is the freedom it
gives the portfolio manager to
take advantageof a larger number
of opportunities to add value than
are afforded by domestic markets
alone.
We use the equilibrium concept
here to calculate the value of global diversification for a bond
portfolio, an equity portfolio and
0
U a portfolio containing both bonds
0
and equities (in each case both
with and without allowing currency hedging). We normalize
.u
the portfolio volatilities
at
marof
the
10.7%-the
volatility
H
ket-capitalization-weighted portfolio, 80% hedged. Table XVIII
w
shows the additional return available from including international
Z:
assets relative to the optimal domestic portfolio with the same
degree of risk.
LU

LU
m

LLI

z
L#)
-J

What is clear from this table is

that global diversification provides a substantial increase in ex40 pected return for the domestic
z-

bond portfolio manager, both in

absolute and percentage terms.
The gains for an equity manager,
or a portfolio manager with both
bonds and equities, are also substantial,although much smaller as
a percentage of the excess returns
of the domestic portfolio. These
results also appear to provide a
justificationfor the common practice of bond portfolio managers
to hedge currency risk and of
equity portfolio managers not to
hedge. In the absence of currency
views, the gains to currency hedging are clearly more important in
both absolute and relative terms
for fixed income investors.

Historical Simulations

Our simulations of all three strategies use the same basic methodology, the same data and the same
underlying securities. The strategies differ in the sources of views
about excess returns and in the
assets to which those views are
applied. All the simulations use
our approach of adjusting expected excess returns away from
the global equilibrium as a function of investor views.
In each of the simulations, we test
a strategy by performing the following steps. Startingin July 1981
and continuing each month for
the next 10 years, we use data up
to that point in time to estimate a
covariance matrix of returns on
equities, bonds and currencies.
We compute the equilibrium risk
premiums, add views according
to the particularstrategy, and calculate the set of expected excess
returns for all securities based on
combining views with equilibrium.

It is natural to ask how a model

such as ours would have performed in simulations. However,
our approach does not, in itself,
produce investment strategies. It
requires a set of views, and any
simulation is a test not only of the
model but also of the strategy
We then optimize the equity,
producing the views.
bond and currency weights for a
One strategy that is fairly well given level of risk with no conknown in the investment world, straints on the portfolio weights.
and that has performed quite well We calculate the excess returns
in recent years, is to invest funds that would have accrued in that
in high-yielding currencies. Be- month. At the end of each month,
low, we show how a quantitative we update the data and repeat the
model such as ours can be used calculation.At the end of 10 years,
to optimize such a strategy. In we compute the cumulative exparticular, we will compare the cess returns for each of the three
historical performance of a strat- strategies and compare them with
egy of investing in high-yielding one another and with several pascurrencies with two other strate- sive investments.
gies-(1) investing in the bonds The views for the three strategies
of countries with high bond represent very different informayields and (2) investing in the tion but are generated using simequities of countries with high ilar approaches. In simulations of
ratios of dividend yield to bond the high-yielding currency stratyield.
egy, our views are based on the
assumption that the expected exOur purpose is to illustrate how a cess returns from holding a forquantitative approach can be eign currency are above their
used to make a useful compari- equilibrium value by an amount
son of alternative investment equal to the forward discount on
strategies. We are not trying to that currency.
promote or justify a particular
strategy.We have chosen to focus For example, if the equilibrium
on these three primarily because risk premium on yen, from a U.S.
they are simple, relatively compa- dollar perspective,is 1% and the
rable, and representative of stan- forward discount (which, because
of covered interest rate parity,
dard investment approaches.

Historical Cumulative Monthly Returns, U.S.-dollar-based perspective

Figure A

$ 600

For example, if the equilibrium

risk premium on equities in a
given country is 6.0% and the
dividendto bond yield ratiois 0.5
with a world averageratioof 0.4,
then we assumethe expected excess return for equities in that
countryto be 11%.We compute
expected excess returnson currencies and bonds by assuming
100%confidence in these views
for equities and adjustingthe returns away from equilibriumin
the appropriatemanner.

Currency Strategy

500

Equilibrium
1

400

300-

200 -

Bond Strategy

00

~~~~~~~~~~Equity

Strategy|

0u
June-'81

Sept-'82

Dec.-'83

Mar.-'85

approximatelyequals the difference between the short rate on

yen-denominated deposits and
the short rate on dollar-denominated deposits) is 2%, then we
assume the expected excess return on yen currencyexposures
to be 3%.We compute expected
excess returnson bonds and equities by adjustingtheir returns
awayfrom equilibriumin a manner consistent with 100%confidence in the currencyviews.

Sept-'87

June-'86

Mar.-'90 June-'91

Dec.-'88

global market-capitalizationweighted average ratio of dividend to bond yield.

views and adjustingreturnsaway

fromequilibriumin the appropriate manner.
In simulations of a strategy of
investingin equity marketswith
high ratios of dividend yield to
bond yield, we generateviews by
assumingthatexpectedexcess returnson equities are above their
equilibriumvaluesby an amount
equal to 50 times the difference
between the ratio of dividendto
bond yield in thatcountryandthe

FiguresA and B show the results

graphically.Figure A compares
the cumulativevalue of $100 invested in each of the three strategies as well as in the equilibrium
portfolio,which is a global market portfolio of equities and
bonds, with 80% currencyhedging. The strategies were structuredto have riskequal to thatof
the equilibriumportfolio.While
the graphgives a clear pictureof
the relativeperformancesof the
differentstrategies,it cannot easily convey the tradeoffbetween
risk and return that can be obtained by takinga more or less

In simulations of a strategy of
investingin fixed income markets
with high yields, we generate Figure B HistoricalRisk/ReturnTradeoffs,July 1981 - August 1991
views by assumingthat expected
excess returns on bonds are
10abovetheirequilibriumvaluesby
an amountequalto the difference
9
Currency Strategy
between the bond-equivalent
8
yield in thatcountryand the global market-capitalizationEquity Strategy
weighted average bond-equivaU.S. Equities U
6 lent yield.
S;

For example, if the equilibrium

riskpremiumon bonds in a given
countryis 1%andthe yield on the
10-yearbenchmarkbond is 2 percentage points above the world
averageyield,thenwe assumethe
expected excess returnfor bonds
in that country to be 3%. We
computeexpected excess returns
on currenciesand equities by assuming 100%confidencein these

5-

P4

/ UnhedgedE
wGlobal
/

GlobalHedged

4-

/
2-

LU

cn

^Equilibrium

Bond Strategy

2U.S.
lIBOR

(N

S. Bonds

-J

U
0-

Risk (%)

10

12

14

16

41

aggressive position for any given

strategy.
Figure B makes such a comparison. Because the simulations have
no constraints on asset weights,
the risk/return tradeoffs obtained
by combining the simulation
portfolios with cash are linear
and define the appropriate frontier for each strategy. We show
each frontier, together with the
risk/return positions of several
benchmark portfolios-domestic
bond and equity portfolios, the
equilibrium portfolio and global
market-capitalization-weighted
bond and equity portfolios with
and without currency hedging.
What we find is that strategies of
investing in high-yielding currencies and in the equity markets of
countries with high ratios of dividend yields to bond yields have
performed remarkably well over
the past 10 years. By contrast, a
strategy of investing in highyielding bond markets has not
added value. Although past performance is certainly no guarantee of future performance, we
believe that these results, and
those of similar experiments with
other strategies, suggest some interesting lines of inquiry.

Conclusion

r54

0)
0)
cl:

Quantitativeasset allocation models have not played the important

role that they should in global
portfolio management. We suspect that a good part of the problem has been that users of such
models have found them difficult
to use and badly behaved.

LLJ

views. By adjusting the confi- 6. The equilibrium-risk-premidence in his views, the investor
ums vector HIis given by Hl =
can control how strongly the
8K:W,where 5 is a proportionviews influence the portfolio
ality constant based on the forweights. Similarly,by specifying a
mulas in Black."8
ranking of confidence in different
views, the investor can control 7. The expected excess return,
E[R],is unobservable. It is aswhich views are expressed most
sumed to have a probability
strongly in the portfolio. The indistribution that is proporvestor can express views about
tional to a product of two northe relative performance of assets
mal distributions. The first
as well as their absolute perfordistribution represents equimance.
librium; it is centered at 1I
with a covariance matrix r-,
We hope that our series of examples-designed to illustrate the
where r is a constant. The secinsights that quantitative modelond distribution represents
ing can provide-will stimulate
the investor's views about k
linear combinations of the elinvestment managers to consider,
or perhaps to reconsider, the apements of E(R]. These views
plication of such modeling to
are expressed in the following
form:
their own portfolios.

Appendix

PE[R] =

1. n assets-bonds, equities and

currencies-are indexed by i
= n,...,n.

Here P is a known k *n matrix, Q

is a k-dimensional vector, and ? is
an unobservable normally distributed random vector with zero
mean and a diagonal covariance

2. For bonds and equities, the

market capitalization is given
by Mi.
3. Marketweights of the n assets
are given by the vector W =
{W1, ... ., W,J. We define

We have learned that the inclusion of a global CAPMequilib4

z
rium with equities, bonds and
currencies can significantly improve the behavior of these models. In particular, it allows us to
Ul
distinguish between the views of
4:D
the investor and the set of ex4
pected excess returns used to
4
drive the portfolio optimization.
This distinction in our approach
z
allows us to generate optimal
4portfolios that start at a set of
neutral weights and then tilt in
42 the direction of the investor's

If asset i is a bond or equity:

Mi

Wi=

-J
Fz

8. The resulting distribution for

E[R is normal with a mean
E[RI:
E[R]= [(72)-1 + Pf-V1P]-1
lrH+ P'0 - 1Q].
[(,Ty,
In portfolio optimization, we use
E[R] as the vector of expected
excess returns.

If asset i is a currency of the jth

Footnotes
country:
1. For some academic discussions of
Wi = AWjcl

LL

L/,I
LU
r-

matrixQ.

the

Wis as follows:

0~

LU

Q+

where Wjc is the country weight

(the sum of market weights for
bonds and equities in the jth
country) and A is the universal
hedging constant.
4. Assets' excess returns are
iven by a vector R=
R1, . . .,

5. Assets excess returns are normally distributed with a covariance matrix L:.

this issue, see R. C Green and B.

Hollifeld, "WhenWill Mean-Variance Efficient Portfolios Be Well
Diversified?"Journal of Finance,
forthcoming, and M j Best and
R. R. Grauer, "On the Sensitivityof
Mean-Variance Efficient Portfolios
to Changes in AssetMeans: Some
Analytical and Computational Results," Review of Financial Studies 4
(1991), pp. 16-22.
2. H Markowitz, "PortfolioSelection,"
Journal of Finance, March 1952; j
Lintner, "TheValuation of RiskAssets and the Selection of RiskyInvestments in Stock Portfolios and
Capital Budgets," Review of Eco-

nomics and Statistics,February

1965; and W F Sbarpe, "Capital
Asset Prices:A Theory of Market
Equilibrium Under Conditions of
Risk," Journal of Finance, September
1964
3. F Black, "UniversalHedging: How
to Optimize Currency Risk and Reward in International Equity Portfolios," Financial AnalystsJoumaL
July/August 1989.
4 In actual applications of the model,
we typically include more asset
classes and use daily data to measure more accurately the current
state of the time-varying risk structure. We intend to address issues
concerning uncertainty of the covariances in another paper. For the
purposes of this article, we treat the
true covariances of excess returns
as known.
5. We define excess return on currency-hedged assets to be total return
less the short rate and excess return
on currency positions to be total
return less theforward premium. In
Table II, all excess returns and volatilities are percentages. The currency-hedged excess return on a bond
or equity at time t is given by:

Et =

Pt + l/Xt + 1

* 100

Pt/xt
-

(1 + Rt)FXt-Rt,

where P, is the price of the asset in

foreign currency, Xt the exchange
rate in units offoreign currency
per US dollar, R, the domestic short
rate and FX, the return on a forward contract, all at time t. The
return on a forward contract or,
equivalently, the excess return on a
foreign currency, is given by:
Ftt +1 -

FXt=

xt

t1 1

' 100,

where F't+' is the one-periodforward exchange rate at time t.

6 We choose to normalize on 10. 7%
risk here and throughout the article
because it happens to be the risk of
the market-capitalization-weighted
80% currency-hedgedportfolio that
will be held in equilibrium in our
model.
7. For the purposes of this exercise, we
arbitrarily assigned to each country
the average historical excess return
for
across countries, as follows-.2
currencies, 0.4 for bonds and 5.1
for equities.

8. See Black, "UniversalHedging," op.

cit
9. The "universal hedging" equilibrium is, of course, based on a set of
simplifying assumptions, such as a
world with no taxes, no capital
constraints and no inflation. Exchange rates in this world are the
rates of exchange between the different consumption bundles of individuals of diferent countries. While
some may find the assumptions that
justify universal hedging overly restrictive, this equilibrium does have
the virtue of being simpler than
other global CAPMequilibriums
that have been described elsewhere.
(See B. H. Solnik, "AnEquilibrium
Model of the International Capital
Market,"Journal of Economic Theory, August 1974, or F. L. A.
Grauer, R. H Litzenbergerand R. E
Stehle, "SharingRules and Equilibrium in an International Capital
Market Under Uncertainty," Journal
of Financial Economics 3 (1976),
pp. 233-56) While these simplifying
assumptions are necessary to justify
the universal hedging equilibrium,
we could easily apply the basic idea
of this article-combining a global
equilibrium witb investors'
views-to another global equilibrium derivedfrom a different, less
restrictive,set of assumptions.
10. Views can representfeelings about
the relationships between observable
conditions and such relative values.
11. In this article we use the term
"strength"of a view to refer to its
magnitude. We reservethe term
"confidence"to refer to the degree of
certainty with which a view is held.
12. We try here to develop the intuition
behind our approach using some
basic concepts of statistics and matrix algebra. A more formal mathematical description is given in the
appendix.
13. A 'prime" symbol (e.g., P') indicates
a transposed vector or matrix.
14. H Theil, Principles of Econometrics
(New York:Wiley and Sons, 1971).
15. F Black and R. Litterman, "Asset
Allocation: Combining Investor
Views with Market Equilibrium"
(Goldman, Sachs & Co., September
1990).
16 For details of these views, see the
following Goldman Sachs publications: The International Fixed Income Analyst August 2, 1991, for
interest rates and The International
Economics Analyst,July/August
1991, for exchange rates.
17. We discuss this situation later.

18. Black, "Universal

Hedging,"Op. Cit

a)

0)

ui

co

:
LLJ
LX

0
L/,
-

z
-J

z
L4

43