The Black-Litterman Model Explained

Active portfolio management is about leveraging information. The Black and Litterman Global Portfolio Optimisation Model (BL) sets information processing in a Bayesian analytic framework. In this framework, the portfolio manager needs only produce views and the model translates the views into security return forecasts. As a portfolio construction tool, the BL model is appealing both in theory and in practice. Although there has been no shortage of literature exploring it, the model still appears somehow mysterious, and suffers from practical issues. This article is dedicated to enabling a better understanding of this model, and features: an economic interpretation; a clarification of the model's assumptions and formulation; implementation guidance; a dimension-reduction technique to enable large portfolio applications; and a full proof of the main result in the Appendix. We also provide a checklist of other practical issues that we aim to address in our forthcoming articles.