Journal of Investment Strategies

Risk.net

Black–Litterman, exotic beta and varying efficient portfolios: an integrated approach

Ricky Alyn Cooper and Marat Molyboga

  • We combine Black-Litterman, exotic betas and risk parity in a unified framework.
  • We express exotic betas as expert “opinions” of the Black-Litterman optimization.
  • We demonstrate risk parity is an effective starting point of the Black-Liiterman framework.

This paper brings Black–Litterman optimization, exotic betas and varying starting portfolios together into one complete, symbiotic framework. The approach is unique because these techniques are often viewed as alternatives rather than as complements to each other. We first demonstrate the approach using exotic beta as the “views” in the Black–Litterman optimization. This framework benefits investors who already utilize the classic Black–Litterman approach and appreciate advances in the exotic beta research, and also those who focus on practical implementation of exotic betas. We then explore the framework using the risk-parity portfolio as an efficient starting portfolio for Black–Litterman optimization on both theoretical and practical grounds. We demonstrate that risk parity is a highly effective starting point in many situations. Finally, as part of our discussion, we derive conditions under which almost any completely diversified portfolio may be used as a starting portfolio in the Black–Litterman process. The integrated methodology developed is robust, flexible and easily implemented, which means that a wide range of investors can benefit from this framework.

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