Diversification Return, Portfolio Rebalancing, and the Commodity Return Puzzle

TL;DR

This paper clarifies that diversification return in rebalanced portfolios stems from the rebalancing process itself, not variance reduction, and applies this insight to resolve puzzles in commodity futures returns.

Contribution

It demonstrates that rebalancing drives diversification return, providing a new explanation for commodity futures index performance and resolving related puzzles.

Findings

Rebalancing causes diversification return by forcing asset sales and purchases.

The source of commodity index returns is clarified as rebalancing effects.

Diversification return can significantly contribute to volatile asset portfolios.

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.