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What is the Black-Litterman model?

The biggest new feature of AllocationADVISOR 6.0 is the inclusion of the BlackLitterman model. The Black-Litterman model was created by Fischer Black and Robert
Litterman of Goldman Sachs. Conceptually, it combines a number of the pillars of
modern portfolio theory Sharpes CAPM and Markowitzs mean-variance optimization.
The Black-Litterman model is not an alternative or a replacement of mean-variance
optimization; it is a tool for creating a set of expected returns for use within the
mean-variance optimization framework.
Harry Markowitzs mean-variance optimization is the heart of modern asset allocation.
Unfortunately, a number of people dont use mean-variance optimization because the
resulting asset allocations are highly concentrated in just a few of the assets being
optimized. The Black-Litterman model eliminates this problem by creating better
estimates of expected return that carefully balance risk and return, leading to welldiversified portfolios.
For more information about how the Black-Litterman Forecast Model leads to diversified
portfolios, see the article Black-Litterman: Asset Allocations You Can Actually Use!
For a discussion about how the Black-Litterman model calculates forecasts, see How
does the Black-Litterman Model Calculate Return Forecasts?

How do you create a Black-Litterman Asset Allocation Case?


We have gone to great efforts to make this sophisticated model easy to use. To create an
Asset Allocation case using the Black-Litterman Forecast model, after naming the
Allocation Case and selecting the Black-Litterman Forecast Model, you begin by
selecting the assets to optimize. Zephyr groups some of the most popular asset classes
together in what we call Asset Palettes. Technically, Asset Palettes are collections of
Market Cap Assets, where Market Cap Assets are asset class index proxies that are linked
to an estimate of the market capitalization of the asset class in question. Using Asset
Palettes created by Zephyr makes it very easy to select a logical set of asset classes.
Zephyr-created Asset Palettes are groups of non-overlapping asset classes that represent
reasonable market portfolios or segments of a market portfolio. AllocationADVISOR
also allows users to create Custom Palettes. The ability to select a predefined Asset
Palette can dramatically decrease the time required to create an asset allocation analysis.
After selecting the Asset Palette, you need to enter a Risk-Premium and a Risk-Free Rate.
For those that need assistance in estimating these values we provide the historical 10, 25,
and 50 year risk premia on six model portfolios, as well as the annual yield on the 3month, 1-year, 5-year, and 10-year US Treasuries. The historical risk-premia and annual
yield data is updated monthly and distributed with Zephyrs Full Index Update.

Select an
Asset
Palette

Enter
Palette Risk
Premium

Enter
Risk-Free
Rate

We encourage you to select


your own Palette Risk
Premium and Risk-Free Rate.
For those who need
assistance selecting
appropriate values, these two
dialog boxes provide
guidance.

After specifying a Palette Risk Premium and a Risk-Free Rate, all that you need to do is
select Done and an Efficient Frontier graph and Inputs table for the Allocation Case are
added to your workbook.

How do you incorporate your unique forecasts of returns?


For those of you who wish to modify the return forecasts to match your own opinions
about future market performance, the Black-Litterman model provides an elegant
framework for combining a base case set of market implied returns with your unique
forecasts. The new mixed Forecast Returns still lead to well-diversified portfolios that
reflect your opinions.
Your unique forecasts of expected returns are called Views. There are two types of
Views Absolute Views and Relative Views each of which is entered on their
respective windows in the Allocation Case tree.
Absolute Views state your unique return forecast of an asset class or group of asset
classes. For example, US Small Cap will have a return of 11.5%.

Enter View
Return and
Confidence

US Small Cap is actually a combination of two asset classes US Small Cap Growth and
US Small Cap Value. The formation of View Groups gives you greater flexibility for
specifying views.

View Groups give


you greater
flexibility for
specifying views

Relative Views specify the expected return differential between two asset classes / view
groups. For example, US Large Cap Growth will outperform US Large Cap Value by
1%.

Enter View
Return and
Confidence

For both types of views, you need to specify a confidence level between 5% and 95%.
This confidence level represents the strength of your view. All else equal, the more
confidence you assign to a View, the more aggressively the model will implement that
view.
Once you have specified your views, select Done.

How do you show two efficient frontiers on the same graph?


One of the most requested features that has been added to AllocationADVISOR is the
ability to show two efficient frontiers on the same graph.

In addition to two efficient frontier graphs, you can also plot the benchmark on the
Efficient Frontier graph. The efficient frontier options are available from a right-click
menu.

Multiple Custom Portfolios


AllocationADVISOR 6.0 allows users to enter multiple custom portfolios in their
allocation cases. These can be any portfolio that users wish to compare to the efficient
portfolios, such as a current portfolio or a target portfolio. Users can select which of the
custom portfolios will be the Comparison Portfolio, which can be displayed on many of
the graphs and tables.

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Monte Carlo Enhancements


We also made two enhancements to the Monte Carlo Simulations for this release. The
first is the ability to enter moving average cash flows. We have also changed the colors
on the Simulation Probability graph, making it easier to distinguish between the different
probabilities.

Conclusion
AllocationADVISOR 6.0 includes the Black-Litterman model, one of the most
sophisticated asset allocation models. Best of all, we have removed the complexity
associated with the model making it intuitive and very easy to use. At last, you will be
able use a mean-variance optimizer and feel good about the resulting allocations. A copy
of the workbook used to create the sample illustrations is available on our web site in the
HTML version of this article.
(http://www.styleadvisor.com/resources/newsletters/NewInAA.html)
For additional information on the Black-Litterman model, see the article The BlackLitterman: Asset allocation you can actually use!
(http://www.styleadvisor.com/resources/newsletters/BLPortfolios.html)

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Black-Litterman: Asset Allocations You Can Actually Use!


Have you given up on mean-variance optimization because the resulting asset allocations
are unintuitive and anything but diversified? Or perhaps you feel the need to use meanvariance optimization coupled with tight optimization constraints? The inclusion of the
sophisticated Black-Litterman asset allocation model into AllocationADVISOR will help
you realize the benefits of mean-variance optimization.
Portfolios created using the Black-Litterman approach and mean-variance optimization
are well diversified and intuitively reflect the investors own forecasts about future
market performance.
Harry Markowitzs mean-variance optimization is widely regarded as the holy grail of
asset allocation. Markowitzs seminal work demonstrated how to form efficient
portfolios based on three inputs returns, standard deviation, and correlations. His work
resulted in a Nobel Prize. Unfortunately, Markowitz never told us how to derive the
inputs, especially the estimated expected returns.
Unlike a number of other Nobel Prize winning ideas, mean-variance optimization has not
enjoyed a high level of practitioner acceptance. This is because the Markowitz algorithm
is very powerful, perhaps too powerful for its own good. The algorithm is very sensitive
to the return forecasts, which have traditionally been created using historical returns. If
two asset classes are similar, but one has a slightly higher forecasted return, the optimizer
allocates everything to the asset with the higher forecasted return and nothing to the other
asset. Because of this input sensitivity, mean-variance optimizers can lead to highly
concentrated asset allocations that contradict the common sense notion of diversification.
The input sensitivity also makes it difficult for investors to incorporate their own
forecasts into a historical model.
Many investors have attempted to overcome these shortcomings in mean-variance
optimization by using tight constraints on the optimization. These artificial limits
interfere with the optimization in a way that renders the output sub-optimal. The tighter
the constraints, the further you move toward dictating the allocations to the optimizer
instead of optimizing the allocations. The Black-Litterman model, on the other hand,
creates better return forecasts so that it is not necessary to constrain the optimization in
order to create diversified portfolios. This allows investors to harness the power of
mean-variance optimization in a practical and intuitive way.
In the first section below we take a closer look at the poorly diversified asset allocations
that typically result from using purely historical inputs. Next we look at the solution, the
Black-Litterman model, and the well-diversified asset allocations that result from using
returns from the Black-Litterman model. In the second section below we demonstrate
why the Black-Litterman approach to incorporating investors forecasts of future market
performance is superior to an ad-hoc approach.

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Diversified Portfolios
Investors have traditionally used historical returns, standard deviations and correlations
as the inputs for mean-variance optimization. Figure 1 shows an efficient frontier created
using eight years of historical data (the longest period available for this set of indices) for
the forecasts.
Figure 1: Efficient Frontier Based on Historical Returns

While this appears to be a perfectly usable efficient frontier, an examination of the


allocations of the portfolios along the frontier shows that they are poorly diversified.
Figure 2 compares five asset allocations of five mixes corresponding to the approximate
standard deviation levels 5%, 7.5%, 10%, 12.5%, and 15%.
Figure 2: Asset Allocation Mixes Based on Historical Returns

Historical Returns
lead to
concentrated
portfolios

Of the eight available asset classes, none of the optimal asset allocation mixes contain
more than two asset classes. Historical returns lead to poorly-diversified asset
allocations!

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Recall that the goal of mean-variance optimization is to capture the benefit of


diversification and to find asset allocations that maximize expected return for a given
level of risk. Fortunately, there is a solution, albeit a solution that emerged almost 50
years after the creation of mean-variance optimization. AllocationADVISOR 6.0 has a
better tool for estimating expected returns the Black-Litterman model.
The Black-Litterman approach tackles the weakest point of mean-variance
optimizationits sensitivity to the return forecasts. Black-Litterman uses the historical
standard deviations and correlations, values which tend to be stable and make good
forecasts, but develops better estimates of expected returns.
The foundation of the Black-Litterman model is the Implied Returns. To calculate the
Implied Returns we define the market as the set of assets available to the investor. The
Implied Returns are calculated by assuming that the market is in equilibrium (supply for
the assets equals demand) and by using reverse optimization to back out the returns that
would bring about this equilibrium. These calculations require three pieces of
information for the marketthe risk premium, covariance and market capitalizations of
the assets.
If the investor does not wish to add their own views to the forecasts, the Implied Returns
are the Black-Litterman forecasts and are used to create the efficient frontier. Figure 3
shows an efficient frontier created using Implied Returns.
Figure 3: Efficient Frontier Based on Black-Litterman Returns

The superior diversification of the asset allocation mixes that result from the BlackLitterman Implied Returns is demonstrated in Figure 4.

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Figure 4: Asset Allocation Mixes Based on Black-Litterman Returns


Black-Litterman
Implied Returns
lead to diversified
portfolios

Of the eight asset classes, all of the optimal asset allocation mixes contain six or more
of the eight asset classes.
Customizing the Implied Returns with Views
As demonstrated above, the Implied Returns are excellent forecasts for use with meanvariance optimization. Investors, however, often have their own opinions about how the
market is going to behave in the future. These investors often want to adjust the Implied
Returns so that the forecasts better reflect their opinions, or views, on future
performance.
How should an investors views be incorporated into the return forecasts? Why not just
directly edit the Implied Returns so that they reflect the views? As we demonstrate
below, trying to edit the Implied Returns directly leads once again to non-diversified
portfolios. The Black-Litterman model, on the other hand, gives you an intuitive way to
incorporate views without losing the advantage of diversification which comes from
using the Implied Returns.
For our examples we will use two sample views:
View 1: US Large Cap Value will outperform US Large Cap Growth by 1%
View 2: US Small Cap will have a return of 11.5%
These Views can be better understood by comparing them to the Implied Returns. The
Implied Returns forecast that US Large Cap Value will under perform US Large Cap
Growth. View 1, then, is a bullish relative view on US Large Cap Value relative to US
Large Cap Growth. View 2 reflects the investors bullish view on US Small Cap. Why?
Because the View return of 11.5% is greater than the Implied Return for US Small Cap
(the weighted average of US Small Cap Growth and US Small Cap Value) which is
10.92%.
Lets look at one possible ad-hoc approach to implementing these views as an example.
For View 1, we could increase the return of US Large Cap Value and simultaneously
decrease the return of US Large Cap Growth until the difference is 1%. And for View 2,
we could increase the return of the two components of US Small Cap so that the weighted
average return equals 11.5%. Figure 5 shows the resulting efficient frontier and mixes.

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Figure 5: Efficient Frontier and Mixes (Ad-hoc Approach)

Ad-hoc approaches
to incorporating
views lead to
concentrated
portfolios

We can see from the allocations in Figure 5 that even though we started with the BlackLitterman Implied Returns, which we have seen lead to well-diversified asset allocations,
the ad-hoc approach to incorporating the views leads to relatively concentrated asset
allocations.
The Black-Litterman model offers an alternative to this kind of ad-hoc adjustment of the
return forecasts. The Black-Litterman model uses a sophisticated mixed estimation
technique to incorporate views into return forecasts which continues to derive returns as a
relatively balanced function of risk. The result is diversified portfolios whose allocations
reflect the views of the investor.
Figure 6 shows the mixes created by using the Black-Litterman approach to incorporate
our two sample views.

Figure 6: Asset Allocation Mixes Based on Black-Litterman Approach

Black-Litterman
approach leads to
well-diversified
portfolios that
reflect views

Notice in Figure 6 that at each of the five standard deviation levels we have achieved
improved diversification using the Black-Litterman model relative to the ad-hoc
approach.

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The other advantage to using the Black-Litterman approach to include views in the
optimization is that the resulting portfolios are affected in an intuitive way. This means
that if you are bullish on Small Cap, the mixes will increase the allocation to Small Cap
by a reasonable amount. While this may sound like an obvious (and necessary) result,
those of you who have attempted to adjust return forecasts manually will recognize that it
is not necessarily easy to achieve.
Figure 7 compares the asset allocation mixes at each of the five standard deviation levels
using the Black-Litterman case without views (just using the Implied Returns) and the
Black-Litterman case with views.
Figure 7: Asset Allocation Mix Comparison

The upper panel of Figure 7 shows the allocations using the Black-Litterman approach
without views while the lower panel shows the allocations using the Black-Litterman
approach with our two sample views. Remember that the sample views were bullish on
US Large Cap Value and Small Cap. Note that the allocations reflect these views in an
intuitive way, with increased allocations to these two assets.
Whats Next
Hopefully by now you are anxious to start using the AllocationADVISORs BlackLitterman Forecast Model. If you havent already done so, you will need to download
AllocationADVISOR 6.0. The AllocationADVISOR workbook file that was used to
create all of the examples in this newsletter is available for download on the html version
of this article: http://www.styleadvisor.com/resources/newsletters/BLPortfolios.html

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We will be hosting a number of AllocationADVISOR 6.0 WebEx online training


sessions. Our online training schedule is available on our website at:
http://www.styleadvisor.com/training.
For a non-technical discussion of how the Black-Litterman model calculates forecasts,
see How does the Black-Litterman Model Calculate Return Forecasts?
For those of you who would like to know more about the mathematics of the BlackLitterman model and our implementation of it, go to the Black-Litterman Forecast
Methodology section of the AllocationADVISOR manual. This section of the manual
explains reverse optimization, the process of creating Market Cap Assets, and the Zephyr
Asset Palettes. The AllocationADVISOR manual is located in your Style folder as well
as the Start Menu StyleADVISOR Program Group.
For the mathematically inclined, a copy of A Step-By-Step Guide to the BlackLitterman Model: Incorporating User-Specified Confidence Levels is available upon
request (support@styleadvisor.com).

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How does the Black-Litterman Model Calculate Return Forecasts?


Several techniques for creating better return forecasts for use with mean-variance optimization
have been developed recently. We believe that we have found the best of these solutions and
we have incorporated it into AllocationADVISOR. The Black-Litterman forecast model creates
return forecasts which are based on sound economic theory and which help harness the power
of mean-variance optimization. Using Black-Litterman return forecasts in mean-variance
optimization results in intuitive, diversified portfolios which are relevant for practical investing.
For more information about how Black-Litterman leads to diversified portfolios, see the article
Black-Litterman: Asset allocations you can actually use! located on our website at:
http://www.styleadvisor.com/resources/newsletters/BLPortfolios.html
How does the Black-Litterman method create return forecasts?
The model uses a technique called reverse optimization to determine the Implied Returns of a
portfolio based on the available market capitalization of the asset classes being optimized. It
also provides a framework to mix investor views with the Implied Returns to form a new
combined estimate of returns.

Implied Returns
Black-Litterman return forecasts are based on the Implied Returns. Implied Returns is a
concept which is based on market equilibrium. The investor first selects an asset palette, which
is the set of assets that will be optimized. This asset palette is assumed to be the market. We
further assume that the market is in equilibrium. Equilibrium really means that the market
price is such that supply equals demand. In this case, we are assuming that the supply of assets
is equal to the demand for the assets. When we are talking about assets, the price becomes a
return. It is the return that is implied by the market equilibrium that we want to find. This is the
Implied Returns.
What is the market equilibrium? If we believe in efficient markets, then the market today is in
equilibrium. The equilibrium portfolio, then, is the market portfolio. The market portfolio is
the capitalization-weighted portfolio of the assets.
Most of the time investors will use multiple asset classes when creating an asset allocation. In
order to demonstrate the mathematics behind the model without resorting to matrix algebra
(which is beyond the scope of this article) we will look at a simple three asset example:
Asset
US Equity
US Bonds
Intl Equity

Market Cap
$ 11,498
$ 8,280
$ 10,350

The Implied Returns, as the name suggests, are the returns which are implied by the capweighted market portfolio. The Implied Returns are calculated using reverse optimization.
This is sometimes referred to as backing out the returns. There are three components of the

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calculation of Implied Returns, the Risk Aversion Coefficient, the Covariance Matrix and the
Market Portfolio Weights.
To start, we will calculate the Implied Excess Returns. At the end we will convert these to
Total Returns. In order to keep this article as user-friendly as possible, we will spell out as
much as possible, and avoid using symbols.
Implied Excess Returns = Risk Aversion Coefficient * Covariance * Market Capitalization Weights

Lets look at the three components of this calculation.


The Risk Aversion Coefficient (RAC)
The Risk Aversion Coefficient (RAC) is the rate at which more return is required for more risk.
It is the palette risk premium divided by the variance of the asset palette. The variance is
calculated using the historical returns for the assets. The risk premium is entered by the user.
Risk Premium

Risk Aversion Coefficient =


Variance

The forward looking Risk Premium is one of the most contentious topics in finance. The equity
Risk Premium is the expected excess return of equity over the Risk-Free Rate. For the
calculation of the Implied Returns, the Risk Premium is an estimate of the Asset Palettes
excess return over the Risk-Free Rate. The Asset Palette Risk Premium acts as a scaling factor
in the reverse optimization process. While we recommend that you select a reasonable number,
the actual number (assuming it is positive) will not change the composition of the efficient
allocations that form the efficient frontier. What is affected by the Risk Premium is the
magnitude of the return forecasts. An unrealistic Risk Premium results in unrealistic forecast
returns leading to unrealistic conclusions regarding future wealth.
For our three asset example we will forecast a Risk Premium of 4%. The Variance of the Asset
Palette is 1.117%.
Risk Aversion Coefficient =

4.00%
1.117%

= 3.404

Covariance (Cov)
The covariance (COV) measures the correlation in the fluctuation of the return series. The most
common example of this is the performance of equity and fixed income. It is generally accepted
that when equity is performing well, fixed income yields tend to be lower. Conversely, when
equity is not performing well, fixed income yields are higher. The covariance captures this
relationship between assets.
The covariance of each pair of assets is calculated using historical correlations and standard
deviations. So, the covariance of Assets A and B is:
Covariance (A,B) = Correlation (A,B) * Standard Deviation (A) * Standard Deviation (B)

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As an example, we will look at the covariances for US Equity:


Cov(US Equity, US Equity) = 0.036
Cov(US Equity, US Bonds) = 0.002
Cov(US Equity, Intl Equity) = 0.010
The other covariances are calculated, and the following covariance matrix is formed:
Covariance
US Equity
US Bonds
Intl Equity

US Equity
US Bonds
Intl Equity
0.036
0.002
0.010
0.002
0.003
0.001
0.010
0.001
0.025

Market Portfolio Weights (MPW)


For the calculation of the Implied Returns we are assuming that the market is in equilibrium.
The equilibrium portfolio is the Market Portfolio. The weights of each of the assets in the
Market Portfolio are calculated using the market capitalization of each of the assets. The weight
given to each asset is proportional to the assets share of the total market cap of the Market
Portfolio. These weights are called the Market Portfolio Weights.
In AllocationADVISOR, users can either select to use assets for which we provide monthly
market cap estimates, or create their own data series with a market capitalization value.
For our three assets, the market caps and weights look like this:

US Equity
US Bonds
Intl Equity
TOTAL

Market Cap
$ 11,498
$ 8,280
$ 10,350
$ 28,980

MPW
38.2%
27.5%
34.4%
100%

As an example, we can look at the calculation of the weight for US equity:

MPWUSEquity =

US Equity Market Cap


Total Market Cap

11,498

28,980

.382

Implied Excess Returns (IER)


Now that we have the three necessary pieces, lets put them together and calculate the Implied
Returns. Due to the nature of the covariance matrix-the second element in the formula-the
calculations are generally made using matrix algebra. It is for this reason that we have chosen

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to use a three asset example in this article. We can now break down the formula for Implied
Excess Returns without having to resort to matrix algebra:

IERUSEquity = RAC *

[ Cov(US Equity, US Equity) *

MPWUS Equity

+ Cov(US Equity, US Bonds) * MPWUS Bonds


+ Cov(US Equity, Intl Equity) * MPWIntl Equity ]

= 3.404 * [.036*.382 + .002*.275 + .010*.344] = 6.05%


Implied Returns
The final step is to turn this Implied Excess Return into a Total Return. To do this, the investor
must make an estimate of the risk-free rate of return. Here, we will use a risk-free rate of 4.5%.
Implied Return = Risk-Free Rate + Implied Excess Return
Implied Return for US Equity = 4.50 + 6.05 = 10.55%
The Implied Return of the other assets is calculated in the same way.

US Equity
US Bonds
Intl Equity

Implied
Return
10.6 %
5.2 %
8.9 %

These implied returns can now be used as return forecasts for mean-variance optimization. The
maximum Sharpe ratio portfolio on an efficient frontier created using Implied Returns is the
market portfolio as you defined it. The fact that the Black-Litterman model recommends
holding the market portfolio if you do not have Views is, from a theoretical standpoint, very
appealing. Movements away from market capitalization weighted holdings are based on Views.
Views
The Implied Returns are excellent forecasts for use with mean-variance optimization. Investors,
however, often have their own opinions about how the market is going to behave in the future.
These investors often want to adjust the Implied Returns so that the forecasts better reflect their
opinions on future performance.
The Black-Litterman method takes an opinion such as I think that US Equity is going to do
well, and quantifies it into something called a View. For this Absolute View, what this really
means is that US Equity is going to do better than the 10.6 % forecasted in the Implied Returns.
The user must decide how much better US Equity will perform, and assign a level of confidence
to the View. The View may then be I believe with 75% confidence that US Equitys return
will be 11.5%.
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Users can also create relative Views. The opinion might therefore be Intl Equity will
outperform US Equity. The Implied Returns forecast the opposite, that US Equity will
outperform Intl Equity. Again, the user must enter the amount of out-performance and a
confidence level. An example is I believe with 85% confidence that US Bonds will
outperform US Equity by 1%.
How are these views incorporated into the return forecasts? The Black-Litterman model uses a
Bayesian approach to incorporating Views into the forecasts while maintaining the advantage of
diversification which comes from using the Implied Returns.
The mathematics of Bayesian probabilities is complicated, but the idea behind it is fairly
straightforward. Bayesian probabilities were designed to incorporate subjective beliefs into
probability distributions. The user starts with a belief, called the Prior distribution. There is
then some event which provides more information, causing the user to wish to modify the
distribution. The event is incorporated into the Prior to form the new belief, the Posterior
Distribution.
When creating return forecasts for mean-variance optimization, the Prior and Posterior
distributions are return distributions. The Prior distribution is the Implied Return distribution.
The events that are incorporated into the Prior distribution are the investors Views. The new
combined return distribution is the Posterior Distribution. These are the returns that are used as
forecasts for mean-variance optimization.
Implied Returns

Views

Black-Litterman Forecast
Returns
For those of you who would like to know more about the mathematics of the Black-Litterman model and our
implementation of it, go to the Black-Litterman Forecast Methodology section in the AllocationADVISOR manual.
This section of the manual explains reverse optimization, the process of creating Market Cap Assets, and the
Zephyr Asset Palettes. The AllocationADVISOR manual is located in your Style folder as well as the Start Menu
StyleADVISOR Program Group.
For the mathematically inclined, a copy of A Step-By-Step Guide to the Black-Litterman Model: Incorporating
User-Specified Confidence Levels is available upon request (support@styleadvisor.com).

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Home Prices in StyleADVISOR


You cant pick up a newspaper today without reading about the boom in single family home
prices. It is, therefore, timely that Zephyr should add a home price data base to the ever growing
list of over 12,000 indexes found in StyleADVISOR. This database includes home price
quarterly returns for fifty states, ten regions and 379 cities starting in 1975. These returns are
computed by the Office of Federal Housing Enterprise Oversight (OFHEO). Our interest in home
prices was prompted by the announcement that the Chicago Mercantile Exchange will begin
trading derivatives on home prices in selected cities. These instruments will allow home owners
to hedge their real estate exposure. Even those who have no interest in these new securities (to be
issued sometime in 2005) should find the home indexes a useful addition to StyleADVISOR.
There are a number of ways that the home price data can be displayed in StyleADVISOR. Figure
1 plots the home price index for Fort Lauderdale (this index also includes Pompano and
Deerfield Beach) in our Performance graph along with the aggregate home price index for the
entire United States. This is the growth of $100 starting December 1, 1975. The red shaded area
at the bottom of the graph measures the cumulative difference between Fort Lauderdale home
prices and the rest of the country. The fact that the cumulative difference was negative for all this
period means that home prices in Fort Lauderdale lagged the country. Figure 2 shows this
relationship broken up into shorter time periods. Here we see the rolling five year difference
between Fort Lauderdale (blue line) and the US (black line). For a short time in the early 1980s
Fort Lauderdale prices outperformed the US but for the rest of the 80s and all of the 90s prices
lagged most of the rest of the country. Since 2001 there has been a sharp increase in Fort
Lauderdale prices relative to the US. In the five year period ending December 2004, Fort
Lauderdale outperformed the US by 6.29% annually. Many believe that this recent relative
strength in Florida real estate is due to the growing retirement of the baby boomers. This could
certainly be a factor, but it doesnt explain the same phenomenon occurring in places like
Bakersfield, Baltimore, Providence RI and many other non-retirement cities.
Figure 1

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Figure 2

Another way to compare Fort Lauderdale and US home prices is to look at the calendar year
returns, as seen in Figure 3. It is interesting to note that the single best calendar year for Fort
Lauderdale was 1980 when home prices increased by 19.02%. The best calendar year for overall
US prices was 1978 with home prices appreciating by 13.32%.
Figure 3

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Figure 4 looks at rolling four quarter (one year) rates of return. We think this graph does the best
job of putting the recent strength in real estate prices into a longer term perspective. Here we can
see that the worst one year return for Fort Lauderdale was the one year ending September 30,
1984 with home prices down 3.37%. The strongest one year period is the one ending September
30, 2004 with prices up 23.89%. Even if we are reluctant to call the recent price appreciation a
bubble, we have to admit that the last few years have not been typical. After a similar price spike
up in 1980, year-to-year home prices in South Florida (as in the US as a whole) were quite
modest. The annual compound growth rate for Fort Lauderdale home prices for the seventeen
years ending December 1999 was 2.37% and for the US was 4.26%.
Figure 4

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Figure 5 shows four tables that we prepared using the search function in StyleADVISOR that
show the best and worst housing markets for the last five and three year periods.
Figure 5

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Using the four graphs (Figures 1-4) we have discussed, we have created two new workbooks that
can be downloaded from our website in the Workbooks section (non-Zephyr clients can
download PDF versions of the workbooks). One workbook incorporates four graphs on one page
for each of the fifty states. A second workbook uses the same analysis for the largest 25 cities. Of
course, Zephyr clients can create their own analysis for any of the 379 cities.
Technical Notes for StyleADVISOR Users
To create the graphs in this example we selected Fort Lauderdale from the Home Prices database
as our manager. For the benchmark we selected the United States returns from the same
database. Figure 2 is our Custom Axis graph. For the Y axis we selected Time and for the X
axis we selected Excess Return vs. United States. We converted plot symbols to lines. These
options can be found on the right click menu (Select Axis Statistics and Convert Plot Series).
Figure 4 is our Manager vs. Benchmark graph. Here we selected rolling return and set the rolling
window at 4 quarters. To run this small window size you must first select none in the Style
Basis selection in Analysis Parameters/Summary.
In all of these graphs we have used the new Dynamic Text function to change the titles and
legends to reflect the actual indexes we are using. So instead of saying Manager vs.
Benchmark it says Fort Lauderdale, Fl vs. United States Return. Because we used dynamic
text this title will automatically change if we select another manager and/or benchmark.
To create the four tables of best and worst three and five year returns we did a search selecting
all 379 cities as managers. We screened returns for the best and worst and highlighted the top
twenty for each category. From the right click menu we selected create workbook for selected
managers. In that workbook we added a custom table and selected the two statistics we
displayed.

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