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Diversification Return, Portfolio Rebalancing, and the Commodity Return Puzzle

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  • Scott Willenbrock

    (University of Illinois at Urbana-Champaign)

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    Abstract

    Diversification return is an incremental return earned by a rebalanced portfolio of assets. The diversification return of a rebalanced portfolio is often incorrectly ascribed to a reduction in variance. We argue that the underlying source of the diversification return is the rebalancing, which forces the investor to sell assets that have appreciated in relative value and buy assets that have declined in relative value, as measured by their weights in the portfolio. In contrast, the incremental return of a buy-and-hold portfolio is driven by the fact that the assets that perform the best become a greater fraction of the portfolio. We use these results to resolve two puzzles associated with the Gorton and Rouwenhorst index of commodity futures, and thereby obtain a clear understanding of the source of the return of that index. Diversification return can be a significant source of return for any rebalanced portfolio of volatile assets.

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    File URL: http://arxiv.org/pdf/1109.1256
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1109.1256.

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    Date of creation: Sep 2011
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    Publication status: Published in Financial Analysts Journal, Volume 67, No. 4, 2011, p. 42-49
    Handle: RePEc:arx:papers:1109.1256

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    Web page: http://arxiv.org/

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