Diversification Returns, Rebalancing Returns and Volatility Pumping

Abstract

There is now a substantial literature on the effects of rebalancing on portfolio performance. It is widely argued in the theoretical literature that rebalanced strategies are inherently likely to generate greater terminal wealth than unrebalanced strategies, although empirical studies do not generally support this claim. We show that this claim is based on a misattribution between 'rebalancing returns' which are specific to the act of rebalancing, and 'diversification returns' which can be earned by both rebalanced and unrebalanced strategies. Confusion appears to have increased because in some situations these two distinct effects have the same magnitude. This issue has important implications for return attribution in diversified portfolios. Misleading claims about the benefits of rebalancing are likely to lead investors into strategies which involve insufficient diversification and excessive transactions costs.

Geometric Characterization of Maximum Diversification Return Portfolio via Rao’s Quadratic Entropy

“…Attributes include diversification through variance reduction [10] and rebalancing [32]. More discussions and debates on those two attributes among others can be found in [14,27,4,5,25,18]. The extensive empirical results conducted in [20] confirm that maximizing the diversification return leads to attractive alternatives to competing smart portfolios.…”