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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)

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.

Suggested Citation

  • Scott Willenbrock, 2011. "Diversification Return, Portfolio Rebalancing, and the Commodity Return Puzzle," Papers 1109.1256, arXiv.org.
  • Handle: RePEc:arx:papers:1109.1256
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    Cited by:

    1. repec:eee:ememar:v:31:y:2017:i:c:p:1-15 is not listed on IDEAS
    2. Soumik Pal & Ting-Kam Leonard Wong, 2016. "Exponentially concave functions and a new information geometry," Papers 1605.05819, arXiv.org, revised May 2017.
    3. Keith Cuthbertson & Simon Hayley & Nick Motson & Dirk Nitzsche, 2016. "What Does Rebalancing Really Achieve?," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 21(3), pages 224-240, July.
    4. Prehn, Sören & Glauben, Thomas & Loy, Jens-Peter & Pies, Ingo & Will, Matthias Georg, 2014. "The impact of long-only index funds on price discovery and market performance in agricultural futures markets
      [Der Einfluss von Long-only-Indexfonds auf die Preisfindung und das Marktergebnis an la
      ," IAMO Discussion Papers 147, Leibniz Institute of Agricultural Development in Transition Economies (IAMO).
    5. Zaremba, Adam & Szyszka, Adam, 2016. "Is there momentum in equity anomalies? Evidence from the Polish emerging market," Research in International Business and Finance, Elsevier, vol. 38(C), pages 546-564.
    6. Adam Zaremba, 2016. "Is there a low-risk anomaly across countries?," Eurasian Economic Review, Springer;Eurasia Business and Economics Society, vol. 6(1), pages 45-65, April.
    7. Ting-Kam Leonard Wong, 2017. "On portfolios generated by optimal transport," Papers 1709.03169, arXiv.org, revised Sep 2017.
    8. repec:kap:rqfnac:v:50:y:2018:i:1:d:10.1007_s11156-017-0621-5 is not listed on IDEAS

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