Building Systematic Views for Black-Litterman Portfolios

Summary

The discussion considers replacing discretionary Black-Litterman views with systematic signals. The proposed example estimates each stock’s residual return from a market model, standardizes residual averages by their volatility, and uses the difference between two stocks to express a relative expected-return view. A scaling constant would control the magnitude of that view, while a separate confidence parameter determines how strongly it influences the posterior portfolio estimates.

The response accepts that systematic views can be formulated, but flags the assumptions and design choices that remain unresolved. In particular, interpreting single-stock residuals through CAPM relies on a model that may not describe those returns well. The investor must also specify a prior, such as market equilibrium, and choose confidence in the systematic view; Black-Litterman blends the prior and views according to that confidence. The exchange offers conceptual guidance rather than a tested method for selecting the scaling or uncertainty parameter, and it questions the value of mixing a systematic strategy with an equilibrium prior if the strategy already works.

Key ideas

• Systematic signals can be expressed as relative-return views within a Black-Litterman framework.
• The example derives views from standardized residual returns under a market model.
• Scaling controls view magnitude, while confidence controls its influence relative to the prior.
• Single-stock residual views depend on model assumptions that may be unreliable.
• The discussion does not establish a validated method for choosing view uncertainty or scaling.

Tags

# Systematic Views in Black-Litterman?


# Systematic Views in Black-Litterman?












Are there any literature on selecting systematic views for Black-Litterman along with methods to specify the uncertainty parameter?

For example, rather than specifying a portfolio manager's subective belief, we perhaps scale a belief based on a historical residual return of a stock based on the market model. e.g if $\epsilon_i = r_i - (\hat{\alpha} + \hat{\beta}R_m)$ then one view can be that stock one is expected to outperform stock two by $1/K *(\frac{\bar{\epsilon_1}}{\sigma_{\epsilon_1}} - \frac{\bar{\epsilon_2}}{\sigma_{\epsilon_2}})$ where $K$ is some scaling constant to ensure that views are accounted for.

Just a crazy thought.

## Answer by Richi Wa (score 2)

https://quant.stackexchange.com/a/17774

Yes, you can formulate such a view. A lot of ways to formulate views are described in the literature (one can start here). However, your view is based on the assumption that CAPM works precisely for single stocks. This assumption will be wrong in most cases.

EDIT after a comment by the OP: I think now I understand. You want to replace expert's views (discretionary) by some systematic trading view. I would say: yes why not. But what is your prior? The market equilibrium? How do you choose the confidence in the view? The prior and the view are mixed proportional to the confidence. All in all if you have a systematic approach that works, why use Black-Litterman and mix the system with some prior? Furthermore market equilibrium (a possible prior) is something that works (if at all) on the long run.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.