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Portfolio rebalancing is the simplest and clearest technique that with few exceptions adds incremental value to fixed-weighted multi-asset portfolios. The incremental value, often referred to as diversification return (Willenbrock [2011] and Booth and Fama [1992]), is attributed to the fact that the variance of a fixed-weighted portfolio is in general smaller than the weighted sum of individual variances because of portfolio diversification. As a consequence, the geometric return of the portfolio is greater than the weighted sum of the geometric returns of individual assets. Indeed, the whole is bigger than the sum of its parts!
Portfolio rebalancing is essential for harvesting diversification return. A portfolio composed of a single security (the extreme case of nondiversification) requires no rebalancing and hence yields no diversification return. A diversified portfolio, if left alone and not rebalanced, does not provide diversification return either, and worse still can become nondiversified over time as in the case of capitalization-weighted indices. In other words, diversification and rebalancing are inseparable. But what is the underlying dynamic of rebalancing that leads to a positive diversification return for a typical portfolio? This question is crucial to an understanding of the source of diversification return and in extending the analysis to leveraged long- short portfolios.
It turns out that the underlying portfolio dynamics of long-only unleveraged portfolios is mean reverting (i.e., the strategy of selling winners and buying losers) . A simple example suffices to illustrate the point. Take an example of a two-asset 50/50 portfolio. Suppose Asset 1 returns 50% and Asset 2 returns 0%. In this case, the portfolio will drift to 60/40 (75/125 and 50/125) at the end of the period. To rebalance the portfolio to the original 50/50 mix, we would sell 10% of Asset 1 (the winner) and buy 10% of Asset 2 (the loser). This meanreverting strategy also applies in portfolios with more than two assets. The weights of the assets that have positive excess returns versus the portfolio will drift higher while the weights of assets that have negative excess returns versus the portfolio will drift lower. As a result, rebalancing necessarily requires selling the former group (the winners) and buying the latter group (the losers).
Why could such a mean-reverting strategy generate positive...