Incorporating Black-Litterman views in portfolio construction when stock returns are a mixture of normals

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Official URL: https://dx.doi.org/10.1016/j.omega.2018.11.017

In this paper, we consider the basic problem of portfolio construction in financial engineering, and analyze how market-based and analytical approaches can be combined to obtain efficient portfolios. As a first step in our analysis, we model the asset returns as a random variable distributed according to a mixture of normal random variables. We then discuss how to construct portfolios that minimize the Conditional Value-at-Risk (CVaR) under this probabilistic model via a convex program. We also construct a second-order cone representable approximation of the CVaR under the mixture model, and demonstrate its theoretical and empirical accuracy. Furthermore, we incorporate the market equilibrium information into this procedure through the well-known Black-Litterman approach via an inverse optimization framework by utilizing the proposed approximation. Our computational experiments on a real dataset show that this approach with an emphasis on the market equilibrium typically yields less risky portfolios than a purely market-based portfolio while producing similar returns on average.