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FRM Part II · FRM Exam Part II · Portfolio Construction

A portfolio manager uses the Black-Litterman model. In the absence of any investor views, what does the model use as the starting vector of expected returns for the assets?

The model starts from equilibrium implied returns obtained by reverse optimization from market capitalization weights. With no views, the optimal portfolio simply equals the market portfolio, and views then shift expected returns away from this neutral prior.

  1. AHistorical average returns over the last five years
  2. BEquilibrium (implied) returns derived by reverse optimization from market capitalization weightsCorrect
  3. CReturns forecast by the manager's highest-conviction view
  4. DZero excess returns for every asset

Explanation

Black-Litterman begins with the prior of equilibrium returns obtained by reverse optimizing from market-cap weights, given a risk aversion and covariance matrix. Views then tilt this prior. Historical averages are the input of classical mean-variance optimization that the model tries to avoid.

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