International asset allocation using the market implied cost of capital

Abstract

"The Black and Litterman (Financ Anal J 48(5):28–43, 1992) (BL) approach to portfolio optimization requires investor views on expected asset returns as an input. I demonstrate that themarket implied cost of capital (ICC) is ideal for quantifying those views on a country level. I benchmark this approach against a BL optimization using time-series models as investor views, the equally weighted portfolio, and allocation methods based on stock market capitalization and GDP. I find that the ICC portfolio offers an increase in average return of 2.1 percentage points (yearly) as compared to the value-weighted portfolio, while having a similar standard deviation. The resulting difference in Sharpe ratios is statistically significant and robust to the inclusion of transaction costs, varying BL parameters, and a less strictly defined investment universe."