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Using Alternative Asset Classes in the Black-Litterman Model

Jul 8, 2011 Marc Odo

A common question people have when using the Black-Litterman model is: How do I add alternative asset classes to my line-up of traditional asset classes? There are arguments both for and against the idea of using alternative asset classes in a Black-Litterman framework. I discussed the topic at our 2007 Annual Client Conference and the presentation is on-line. In the near future I hope to draft a case study that will be included in the “Articles” section of our website.

Assuming you do wish to add alternative asset classes to your Black-Litterman palettes, you really only need two things. First, you need an index for the asset class so you can calculate the standard deviations, correlations, etc. Seeing as Zephyr provides over 50,000 capital market indices, finding an index is the easy part. The second piece of information you need is the market capitalization of the asset class. The importance of having a market cap was discussed in a previous ZephyrCOVE post. For many alternatives, this number is tricky to define.

According to HFR, the size of the hedge fund industry recently surpassed $2 trillion in AUM for the first time. This number could be used as a suitable proxy for the “market capitalization” of hedge funds, since it represents the amount of money that investors have moved away from traditional investments to alternative strategies.

With regards to commodities, a recent article in The Economist gave a pretty good ballpark number estimating the dollar value invested in commodities as for investment/speculative purposes. According to the article, Barclays Cap stated there is $320bn institutional and retail money invested in the commodities asset class. I’m not sure if you need a subscription to access the archive, but here is the quote:

“Investors have certainly acquired more of a taste for commodities over the past few years. According to Barclays Capital, around $320 billion of institutional and retail money is now devoted to commodities, compared with just $6 billion a decade ago. That sum does not include hedge funds, whose involvement is significant but difficult to quantify.”- Economist, Nov 11th, 2010 edition, “Commodity Traders: Dr. Evil, or Drivel?”

Hedge funds and commodities are the most frequently-asked alternative asset classes. Again, I hope to have a more thorough case study on the topic available soon.

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