Investments, tenth edition

Quality Control

1. Keep forecast records

2. Estimate quality

3. Adjust forecasts

Micro Analyst

Estimate alpha values

Econometric Unit

1. Estimate betas

2. Estimate σ(e)

3. Help other units

Forecasts

Forecasts

Data

Forecasts

Estimates

Estimates and Help with Statistics

Feedback

Feedback

Overall Portfolio Manager

1. Mix active and passive portfolios

2. Monitor performance of active portfolio

3. Monitor performance of passive portfolio

1. Form active portfolio

2. How good are alpha forecasts?

3. How good are beta + residual

    variance estimates?

Active Portfolio Manager

 Figure 27.4 

Organizational chart for portfolio management  

 Source: Adapted from Robert C. Merton,  Finance Theory,  Chapter 12, Harvard Business School. 

  Fischer Black, famous for the Black-Scholes option-pricing formula as well as the Treynor-

Black model, teamed up with Robert Litterman to produce another useful model of port-

folio construction. The Black-Litterman (BL) model allows portfolio managers to quantify 

complex forecasts (which they call    views   ) and apply these views to portfolio construction.  

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We begin the discussion of the BL model with an illustration of a simple problem of asset 

allocation. Although we devote the next section to a comparison of the two models, some 

comments on commonalities of the models will help us better understand the BL model.