Diversification Returns, Rebalancing Returns and Volatility Pumping

45 Pages Posted: 19 Aug 2013 Last revised: 8 Feb 2016

See all articles by Keith Cuthbertson

Keith Cuthbertson

Simon Hayley

Bayes Business School (formerly Cass), City, University of London

Nick Motson

City University London - Bayes Business School

Dirk Nitzsche

City University London - The Business School

Date Written: January 14, 2015

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.

Keywords: Diversification, rebalancing, volatility pumping

JEL Classification: G10, G11

Suggested Citation

Cuthbertson, Keith and Hayley, Simon and Motson, Nicholas E. and Nitzsche, Dirk, Diversification Returns, Rebalancing Returns and Volatility Pumping (January 14, 2015). Available at SSRN: https://ssrn.com/abstract=2311240 or http://dx.doi.org/10.2139/ssrn.2311240

Simon Hayley (Contact Author)

Bayes Business School (formerly Cass), City, University of London ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Nicholas E. Motson

City University London - Bayes Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Dirk Nitzsche

City University London - The Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

No contact information is available for Keith Cuthbertson

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