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

Abstract

This paper brings together Black-Litterman optimization, exotic betas, and varying starting portfolios into one complete, symbiotic framework. The approach is unique because these techniques are often viewed as alternatives, and not as complements to each other. The paper is comprised of two main sections. The first section demonstrates using exotic beta as the “views” in the Black-Litterman optimization. This approach 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. The second section explores using the risk parity portfolio as an efficient starting portfolio for Black-Litterman optimization on both theoretical and practical grounds. This paper demonstrates 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.