A Mathematical and Empirical Analysis of Rebalancing Alpha

Edward Qian, PhD, CFA

Chief Investment Officer, Multi Asset Group
PanAgora Asset Management

470 Atlantic Avenue, 8th Floor

Boston, MA 02210
617-439-6327
617-790-2642 fax
eqian@panagora.com

October 2014

Electronic copy available at: http://ssrn.com/abstract=2543705

A BSTRACT

Rebalancing alpha is the excess return of a fixed-weight portfolio, which is regularly

rebalanced, over its buy-and-hold counterpart. Two kinds of effects, both results of
portfolio rebalancing, contribute to rebalancing alpha. The first is a volatility effect that
arises from randomness of asset returns. The second is a return effect due to differences in
asset returns. Built on previous studies, we define and analyze mathematically these two
effects and by extension the rebalancing alpha. Our results clarify previous results and
show the rebalancing alpha depends on “t-statistics” of pairwise excess returns. The results
reveal conditions under which the rebalancing alpha is positive. Our analysis also
quantifies explicitly how cross sectional serial correlations influence the return effect and
the rebalancing alpha. We derive additional results for long-short portfolios, which require
special treatments of return effect. Empirical examples with actual returns of asset
allocation portfolios and equity sector portfolios provide verification, additional insights,
and practical understanding of the results.

Electronic copy available at: http://ssrn.com/abstract=2543705

Does portfolio rebalancing generate alpha? To pose the question more specifically, suppose
we follow two portfolios that start with identical initial holdings. The first portfolio is a
buy-and-hold (BH) portfolio, which is allowed to drift freely. As examples, capitalization-
weighted indices are essentially buy-and-hold portfolios. The second portfolio is a fixed-
weight (FW) portfolio, whereas regular portfolio rebalancing brings it back to the initial
weight. The key question is, after some passage of time, given a set of asset returns, does
the FW portfolio outperform the BH portfolio, or vice versa?

The analytic answer to this question has been ambiguous. The proponents of rebalancing
alpha points to diversification return as supporting evidence of rebalancing alpha (Booth
and Fama 1992, Willenbrock 2011, Qian 2012). The detractors of rebalancing alpha, on the
hand, have used probability theory to show portfolio rebalancing does not lead to higher
expected terminal wealth (Chambers and Zdanowicz 2014, Hayley et al 2013). In fact, it
generally leads to lower expected terminal wealth, which would implicate a negative
rebalancing alpha. Recently, the author (Qian 2014a) has confirmed these results for the
general case of long-only portfolios with arbitrary number of assets and arbitrary number
of periods. However, it is also shown (Qian 2014a) that portfolio rebalancing often lowers
variance of terminal wealth thus a FW portfolio could have higher risk-adjusted terminal
wealth than a BH portfolio.

The study of expected terminal wealth, while theoretically appealing and insightful, has
limited applicability in reality. The assumption underlying the results that returns are from
identically and independently probability distributions is certainly not true in reality.
However, these analyses are not without merit amid the discussion of rebalancing alpha.
They are consistent with the effect of return drag caused by portfolio rebalancing identified
in previous studies (Bernstein and Wilkinson 1997, Rulik 2013, Hallerbach 2014).

These results taken together show portfolio rebalancing induces two opposing effects in
terms of relative performance between FW and BH portfolios. The first is a volatility effect,
often referred to as diversification return in the past, which favors FW portfolios in a long-
only setting. It is always positive for a long-only portfolio but could easily be negative for
long-short portfolio (Qian 2012). Therefore, the volatility effect or diversification return

2
does not always lend support to rebalancing alpha. More importantly, as we shall see
shortly, this volatility effect measures the difference between the geometric return of the
FW portfolio and a weighted average of geometric returns, not the difference between the
returns of FW and BH portfolios. Nevertheless, the volatility effect arises because
rebalancing a long-only portfolio entails buying losers and selling winner. Since winners
and losers are to some degree created by randomness (or volatility) of asset returns,
buying losers and selling winners would benefit from reversion to the mean, leading to a
positive contribution for long-only portfolios. It is important to note that this effect
depends solely on return variance and covariance and its presence does not require
negative auto- and cross- correlations in asset returns associated with return reversal.

However, the volatility effect or the diversification return alone is not rebalancing alpha.
Portfolio rebalancing also induces a second effect, caused by differences in average returns
of different assets (Rulik 2013, Hallerbach 2014). For a long-only portfolio, this return
effect is always negative for the FW portfolio. The reason again lies in the mechanics of
portfolio rebalancing, i.e., selling winner and buying losers. When the average returns of
assets are different, portfolio rebalancing over time would sell higher-return assets and
buy lower-return assets, leading to a return drag for the FW portfolio. It is worthy to note
that portfolio rebalancing by nature is a contrarian strategy for long-only portfolios (not
necessarily for long-short portfolios). Therefore, this negative return effect is similar to a
loss term caused by return dispersion in a contrarian strategy (Lo and MacKinlay, 1990).

Therefore, to analyzing rebalancing alpha, we need to consider the net result of both
volatility and return effects, within specific context of portfolio assets, their return
distributions, investment horizon, and portfolio settings. Neither of the two effects alone
corresponds to portfolio rebalancing alpha, except in extreme cases. In addition, as we shall
illustrate explicitly, these two effects and their net effect of long-short portfolios are quite
different from those of long-only portfolios.

In this paper, we first formulate the mathematical problem of comparing geometric returns
of a FW portfolio and its BH counterpart. Specifically we decompose rebalancing alpha into
a volatility effect and a return effect explicitly. We then carry out mathematical analyses of

3
the two effects for long-only portfolios. The approximations of both volatility and return
effects give rise to intuitive conditions under which portfolio rebalancing has either
positive or negative alpha. Next, we consider an extension to long-short portfolios, which
requires additional analysis. We facilitate our analysis and discussion of the results by
using empirical examples from long-only asset allocation and long-only sector portfolios.
For illustration of long-short cases, we use a set of Risk Parity portfolios.

T HE GEOMETRIC RETURNS OF FW AND BH PORTFOLIOS

We have M investable assets and an investment horizon of N periods. We assume that in

the beginning, both FW and BH portfolios are invested in the assets with portfolio weights:
⃗⃗ = (𝑤1 , ⋯ , 𝑤𝑀 )′ and the sum of the weights is one, i.e., 𝑤1 + 𝑤2 + ⋯ + 𝑤𝑀 = 1. For long-
𝑤
only portfolios, all weights are non-negative. For long-short portfolios, some but not all
weights are negative.

We denote return of asset i in period n by 𝑟𝑖𝑛 . For the FW portfolio, the portfolio return is
the weighted sum of individual returns with the fixed weights, i.e.
𝑀

𝑟FW,𝑛 = 𝑤1 𝑟1𝑛 + 𝑤2 𝑟2𝑛 + ⋯ + 𝑤𝑀 𝑟𝑀𝑛 = ∑ 𝑤𝑖 𝑟𝑖𝑛 . (1)

𝑖=1

The geometric return of the FW portfolio with portfolio rebalancing after N periods is
defined by
𝑀 𝑀

(1 + 𝑔FW )𝑁 = (1 + ∑ 𝑤𝑖 𝑟𝑖1 ) ⋯ (1 + ∑ 𝑤𝑖 𝑟𝑖𝑁 ). (2)

𝑖=1 𝑖=1

The geometric return of the buy-and-hold portfolio is given by the following equation
(1 + 𝑔BH )𝑁 = 𝑤1 (1 + 𝑟11 ) ⋯ (1 + 𝑟1𝑁 ) + ⋯ + 𝑤𝑀 (1 + 𝑟𝑀1 ) ⋯ (1 + 𝑟𝑀𝑁 ). (3)

Equation (3) can be written in terms of geometric returns of individual assets: (𝑔1 , ⋯ , 𝑔𝑀 ).
(1 + 𝑔BH )𝑁 = 𝑤1 (1 + 𝑔1 )𝑁 + ⋯ + 𝑤𝑀 (1 + 𝑔𝑀 )𝑁 . (4)

In Equation (4), we have used equations (1 + 𝑔𝑖 )𝑁 = (1 + 𝑟𝑖1 ) ⋯ (1 + 𝑟𝑖𝑁 ), 𝑖 = 1, ⋯ , 𝑀.

Our objective is to compare the two geometric returns, 𝑔FW and 𝑔BH . Given the complexity
of Equation (2) and (4), it is difficult to compare them directly except in certain special
cases. The commonly used approach, which has led to both progress and confusion, is to

4
compare both returns separately to a third “return” term, namely the weighted average of
geometric returns
𝑀

𝑔̅ = 𝑤1 𝑔1 + ⋯ + 𝑤𝑀 𝑔𝑀 = ∑ 𝑤𝑖 𝑔𝑖 . (5)
𝑖=1

It is important to note 𝑔̅ is a fictitious “return” in the sense that it is not the geometric
return of any actual portfolio, and certainly not the geometric return of the BH portfolio.
Nevertheless, we define volatility effect as the difference between the geometric returns of
the FW portfolio and 𝑔̅
𝑒𝑣 = 𝑔FW − 𝑔̅ . (6)

This volatility effect is closely related to diversification return. However, as an attempt to

avoid further confusion, we shall refrain from using the term “diversification return” in the
present paper, because it is neither an absolute return nor a relative return.

Similarly, we define return effect as the difference between the geometric return of the BH
portfolio and 𝑔̅
𝑒𝑟 = 𝑔BH − 𝑔̅ . (7)
As we shall see, the return effect is closely related to the dispersion of returns of individual
assets (thus the name return effect). Finally, the rebalancing alpha is the difference
between the volatility effect and the return effect
𝛼PR = 𝑔FW − 𝑔BH = 𝑒𝑣 − 𝑒𝑟 . (8)
Hence, the rebalancing alpha 𝛼PR is positive when the volatility effect 𝑒𝑣 is larger than the
return effect 𝑒𝑟 . Conversely, it is negative when the volatility effect is smaller than the
return effect.

We shall derive estimates of both volatility and return effect effects next by analytic
approximations. Before doing so, we remark that for long-only portfolios, it can be proven
mathematically that both effects are strictly non-negative, i.e., 𝑔BH ≥ 𝑔̅ and 𝑔FW ≥ 𝑔̅ (Qian
2014b). These inequalities are always true and they do not require any distributional
assumption of returns.

5
T HE APPROXIMATION OF VOLATILITY EFFECT

The derivation of the volatility effect 𝑒𝑣 , which has been given previously (Booth and Fama
1992, Willenbrock 2011, Qian 2012), hinges on a relationship between geometric return
and arithmetic return, namely
1
g ≈ μ − σ2 . (9)
2
In the equation, g and μ are the geometric and arithmetic means of a portfolio over a
number of periods respectively, and σ is the volatility of returns over those periods. This
approximate relationship is valid for any portfolio as long as the means and the volatility of
the portfolio returns are reasonably small. Even though there exist more elaborated
approximations (Mindlin 2011) for the relationship, Equation (9) appears satisfactory for
many assets returns and it is the most analytically tractable for many types of return
analysis. For completeness of our analysis, we derive the volatility effect based on Equation
(9).

Applying Equation (9) to individual assets gives

1
𝑔𝑖 ≈ 𝜇𝑖 − 𝜎𝑖2 , 𝑖 = 1, ⋯ , 𝑀. (10)
2
Taking the weighted average of these equations yields
𝑀 𝑀 𝑀 𝑀
1 1
𝑔̅ = ∑ 𝑤𝑖 𝑔𝑖 ≈ ∑ 𝑤𝑖 μi − ∑ 𝑤𝑖 σ2i = μFW − ∑ 𝑤𝑖 σ2i . (11)
2 2
𝑖=1 𝑖=1 𝑖=1 𝑖=1

The left hand side of the equation is the weighted average of geometric means. The first
term of the right hand side is the arithmetic return of the FW portfolio and we have
denoted it by μFW . It is also related to the geometric return of the FW portfolio 𝑔FW through
Equation (9), i.e.
1
𝑔FW ≈ μFW − σ2FW . (12)
2
Substituting μFW from Equation (12) into Equation (11) and rearranging the terms yield

𝑀
1
𝑒𝑣 = 𝑔FW − 𝑔̅ ≈ 𝑒̃𝑣 = (∑ 𝑤𝑖 σ2i − σ2FW ). (13)
2
𝑖=1

6
Equation (13) provides an approximation of the volatility effect, or diversification return.
Its approximation, 𝑒̃𝑣 , equals half of the difference between the weighted average of
variances of individual assets and the variance of the FW portfolio.

We can rewrite the portfolio variance as a double-weighted sum of variances and

correlations. Equation (13) becomes
𝑀 𝑀
1
𝑒̃𝑣 = (∑ 𝑤𝑖 σ2i − ∑ 𝑤𝑖 𝑤𝑗 𝜌𝑖,𝑗 σi σj ). (14)
2
𝑖=1 𝑖,𝑗=1

We remark that since the approximation (9) is independent of portfolio weights, the
volatility effect derived in Equation (14) is expected to be valid for both long-only and long-
short portfolios.

To gain insights about the volatility effect, we consider a portfolio with just two assets.
Then Equation (14) simplifies to
1 1
𝑒̃𝑣 = 𝑤1 𝑤2(σ12 + σ22 − 2𝜌1,2 σ1 σ2 ) ≜ 𝑤1 𝑤2 𝜎1_2
2
. (15)
2 2
In the last expression, we defined variance of return differences between the two assets.
We note that when weights are positive, Equation (15) gives positive volatility effect. On
the other hand, if we have a long-short portfolio of two assets, the two weights must be of
opposite sign, i.e., one long and one short. Consequently, the volatility effect is negative. As
it is pointed in Qian (2012), rebalancing two-asset long-short portfolios entails buying
winners and selling losers. This results in a negative volatility effect for the FW portfolio.

Equation (15) expresses the volatility effect in terms of the variance of the pair. This
expression can be generalized to the general case of more than two assets (see appendix).
When the number of asset is M, the volatility effect is the sum of all volatility effects from all
distinct pairs
𝑀
1 2
1 ′
𝑒̃𝑣 = ∑ 𝑤𝑖 𝑤𝑗 𝜎𝑖_𝑗 = 𝑤⃗⃗ Σv 𝑤
⃗⃗ . (16)
2 4
𝑖<𝑗

Equation (16) is a new result and it has several powerful implications. First, it states the
volatility effect of a FW portfolio can be decomposed into volatility effects of pairwise
assets. Intuitively, this indicates that even though portfolio rebalancing is carried out for all

7
the assets together, the volatility effect arises from rebalancing of individual pairs. Second,
Equation (16) is another direct proof that the volatility effect is positive for long-only
portfolios unless all distinct pairs of asset show no volatility in return differentials. This is
consistent with the mathematical fact that volatility effect is always non-negative for long-
only portfolios. Third, Equation (16) also has succinct matrix form; the matrix Σv , is the
matrix of pair-wise variances of return differences (see its definition in appendix). This
matrix form of (16) is analogous to that of portfolio variance in terms of portfolio weights
and covariance matrix of asset returns.

Another useful alternative expression of the volatility effect involves variance of return
2
differences between individual assets and the FW portfolio. In this case, we denote 𝜎𝑖_FW as
the variance of excess return of asset i versus the FW portfolio. We then have
𝑀
1 2
𝑒̃𝑣 = ∑ 𝑤𝑖 𝜎𝑖_FW . (17)
2
𝑖=1

This gives rise to the interpretation that the volatility effect is the weighted sum of the
volatility effects between individual assets and the overall portfolio. Both equation (16)
and (17) are derived in an appendix. They shall be useful when we derive conditions for
positive rebalancing alpha.

T HE APPROXIMATION OF RETURN EFFECT

The return effect measures the difference of the geometric return of the BH portfolio 𝑔BH
and the weighted average of the geometric returns of individual assets 𝑔̅ . Equation (4)
which relates these geometric returns together, serves as the starting point for the
derivation of the return effect.

The derivation below is a reformulation of the steps outlined by Hallerbach (2014). We

first approximate each term (1 + 𝑔𝑖 )𝑁 by (1 + 𝑔̅ )𝑁 using a second-order Taylor expansion:

𝑔𝑖 − 𝑔̅ 𝑁 𝑔𝑖 − 𝑔̅ 𝑁(𝑁 − 1) 𝑔𝑖 − 𝑔̅ 2
(1 + 𝑔𝑖 )𝑁 = (1 + 𝑔̅ )𝑁 (1 + 𝑁
) ≈ (1 + 𝑔̅ ) [1 + 𝑁 + ( ) ] . (18)
1 + 𝑔̅ 1 + 𝑔̅ 2 1 + 𝑔̅

The weighted sum of Equation (18) gives rise to

8
 𝑀 𝑀
𝑁(𝑁 − 1)
(1 + 𝑔BH )𝑁 = ∑ 𝑤𝑖 (1 + 𝑔𝑖 )𝑁 ≈ (1 + 𝑔̅ )𝑁 [1 + ∑ 𝑤𝑖 (𝑔𝑖 − 𝑔̅ )2 ]. (19)
2(1 + 𝑔̅ )2
𝑖=1 𝑖=1

The linear term drops out by the definition of 𝑔̅ . We define the weighted variance of the
geometric returns across the assets as, var(𝑔) = ∑𝑀 2
𝑖=1 𝑤𝑖 (𝑔𝑖 − 𝑔̅ ) . Re-approximating the

bracket term on the right hand side of Equation (19) as a power, we have
𝑁 𝑁
(𝑁 − 1) (𝑁 − 1)
(1 + 𝑔BH )𝑁 ≈ (1 + 𝑔̅ )𝑁 [1 + var(𝑔)] = [1 + 𝑔̅ + var(𝑔)] . (20)
2(1 + 𝑔̅ )2 2(1 + 𝑔̅ )

Taking the N-th root of both sides yields an approximation of the return effect 𝑒̃𝑟 . We have
(𝑁 − 1) (𝑁 − 1)
𝑒𝑟 = 𝑔BH − 𝑔̅ ≈ 𝑒̃𝑟 = var(𝑔) ≈ var(𝑔). (21)
2(1 + 𝑔̅ ) 2
The last step is justified if 𝑔̅ is small. Before exploring the return effect in detail, we make
several remarks about Equation (21). First, the weighted variance of geometric returns is
positive when all weights are non-negative. Therefore, Equation (21) gives rise to positive
return effect for long-only portfolios, consistent with the inequality 𝑔BH ≥ 𝑔̅ . Secondly, we
consider the validity of the approximation used to obtain this result. For the sake of Taylor
expansion in Equation (18), the differences 𝑔𝑖 − 𝑔̅ should be small and somewhat
comparable. For example, if one of geometric returns, say 𝑔𝑘 is dominant and 𝑤𝑘 is
moderately positive, then the sum ∑𝑀 𝑁 𝑁
𝑖=1 𝑤𝑖 (1 + 𝑔𝑖 ) will be dominated by 𝑤𝑘 (1 + 𝑔𝑘 ) when

N becomes large. In other words, if one particular asset has a much higher return than the
rest, the return of a BH portfolio 𝑔BH will largely depend on that asset, rendering Equation
(21) less effective; a similar point is made by Bernstein and Wilkinson (1997). Imagine we
have a BH portfolio consisted of cash and equity. Over the long run, the equity return and
its initial allocation are all that matters. In this case, Equation (21) will not be a good
approximation.

Another condition is the weighted variance var(𝑔) has to be reasonably small for Equation
(20). This tends not to be an issue for long-only portfolios. When weights are all non-
negative, the weighted variance is a true variance associated with a set of discrete
probabilities. However, it is a potential problem for long-short portfolios where some
weights are negative. This is because with some negative weights, var(𝑔) is no longer a true

9
variance and the weighted average 𝑔̅ is not a true average either. For example, 𝑔̅ could lie
outside of the range of individual returns. In that case, ∑𝑀 2
𝑖=1 𝑤𝑖 (𝑔𝑖 − 𝑔̅ ) could be rather

large, since some 𝑔𝑖 could be quite far away from 𝑔̅ . Therefore, for long-short portfolios,
Equation (21) could be less satisfactory. We shall derive an alternative version that
provides a more accurate approximation later in the paper.

As before, the case of two assets provides valuable insights. The weighted variance is
var(𝑔) = 𝑤1 (𝑔1 − 𝑤1 𝑔1 − 𝑤2 𝑔2 )2 + 𝑤2 (𝑔2 − 𝑤1 𝑔1 − 𝑤2 𝑔2 )2 = 𝑤1 𝑤2 (𝑔1 − 𝑔2 )2 . (22)
It is positive if both assets have positive weights but it is negative when the weights are of
opposite signs for a long-short portfolio. Thus, the return effect is negative for two-asset
long-short portfolios. Together with Equation (15), we conclude that in two-asset long-
short portfolios, the volatility effect and the return effect are of opposite signs of those in
long-only portfolios, i.e., a negative volatility effect but a positive return effect.

It is worth noting that Equation (22) is of a similar form as Equation (15). It turns out that
we can also generalize Equation (22) for the general case. We have
𝑀 𝑀
2 1 ′
var(𝑔) = ∑ 𝑤𝑖 (𝑔𝑖 − 𝑔̅ )2 = ∑ 𝑤𝑖 𝑤𝑗 (𝑔𝑖 − 𝑔𝑗 ) = 𝑤⃗⃗ Σg 𝑤
⃗⃗ . (23)
2
𝑖=1 𝑖<𝑗

The proof is this identity is checked by algebraic expansion. The matrix Σg consists of
2
element (𝑔𝑖 − 𝑔𝑗 ) , given explicitly in an appendix. Hence, according to Equation (21) and
(23), the return effect is
𝑀
(𝑁 − 1) 2 (𝑁 − 1) ′
𝑒𝑟 = 𝑔BH − 𝑔̅ ≈ 𝑒̃𝑟 = var(𝑔) = ∑ 𝑤𝑖 𝑤𝑗 (𝑔𝑖 − 𝑔𝑗 ) = 𝑤
⃗⃗ Σg 𝑤
⃗⃗ . (24)
2 4
𝑖<𝑗

The impact of cross-sectional serial correlations on return effect

While it is debatable whether return reversal is required for positive rebalancing alpha, it is
universally agreed that cross-sectional serial correlations of asset returns play a role in
rebalancing alpha. It is apparent that return reversal is beneficial to FW portfolio and
return momentum is beneficial to BH portfolios. While this intuition is generally true, the
analysis regarding how cross-sectional serial correlations actually affect rebalancing alpha

10
has been lacking in previous research. The results so far indicate that once the periodicity
of returns are chosen (e.g. monthly or annually), serial correlations should not influence
the volatility effect, which depends on return variances only. They do influence the return
effect, however. We now employ Equation (24) to analyze the impact of serial correlations
on the variance of the geometric returns.

First, we note that geometric return 𝑔 can be approximation by Equation (10) in terms of
arithmetic return and return variance. In most cases, the variability of arithmetic returns of
different assets is far larger than the variability of return variances. Therefore, we focus on
the impact of serial correlations on the variances of arithmetic returns.

By definition, arithmetic returns are simply arithmetic averages of returns over N periods,
we can write
𝜇1
1 𝑟11 + 𝑟12 + ⋯ + 𝑟1𝑁
⋮
( )= ( ⋮ ). (25)
𝜇𝑀 𝑁 𝑟𝑀1 + 𝑟𝑀2 + ⋯ + 𝑟𝑀𝑁

It is more convenient to express the equation in a vector form,

1
𝜇= (𝑟 + 𝑟2 + ⋯ + 𝑟𝑁 ). (26)
𝑁 1

Each vector denotes returns across M assets for a particular period. Taking varianceI of
both sides, we have
1
var(𝜇 ) = var(𝑟1 + 𝑟2 + ⋯ + 𝑟𝑁 ). (27)
𝑁2

The variance of a sum of vectors can be written as a sum of variances of individual vectors
and their covariances, which in turn are products of cross-sectional serial correlations and
dispersions of return vectors. We have
𝑁 𝑁
1
var(𝜇 ) = 2 [∑ var(𝑟𝑗 ) + 2 ∑ 𝜌(𝑟𝑗 , 𝑟𝑘 ) 𝜎(𝑟𝑗 )𝜎(𝑟𝑘 )]. (28)
𝑁
𝑗=1 𝑗<𝑘

We make several remarks. First, Equation (28) is analogous to the formula for calculating
variance of multi-period returns of one asset from variances of single-period returns and
serial auto-correlations of the asset – a process often referred to as annualizing. The slight

11
difference is here we are interested in the variance of average return not the variance of
cumulative return. Second, it is apparent from Euqation (28) that negative cross-sectional
serial correlations would lead to lower variance of arithmetic means thus smaller return
effect from portfolio rebalancing, leading to larger rebalancing alpha in favor of FW
portfolios.

Third, when the cross-sectional serial correlations are all zero, Equation (28) becomes
var(𝜇 ) = (1⁄𝑁 2 ) ∑𝑁
𝑗=1 var(𝑟𝑗 ), or the average of cross-sectional variances divided by N. One

concludes that the variance of arithmetic means (not cumulative return) over the entire
period is much smaller than the average of single-period varianceII.

Fourth, note from Equation (28) the cross-sectional serial correlations cover all lags from 1
to (N-1). It is often the case that for some lags, the correlations are positive (cross-sectional
momentum) while for other lags, the correlations are negative (cross-sectional reversal). It
is the aggregated impact of correlations of all lags that determines their impact on the
variance of arithmetic returns. For example, many asset returns exhibit short-term
momentum. It would be incorrect to conclude on this basis alone that rebalancing alpha
will be negative. The reason is these asset returns might also have long-term reversal,
which portfolio rebalancing will capture over long term. We must weigh their effects
accordingly by Equation (28). An empirical example later in the paper would illustrate this
point.

Some theoretical simplification of Equation (28) would make these points clearer.
Assuming the variances of return vectors are the same for N periods, and the correlations
between return vectors of different periods are stationary, i.e. they only depends on the lag
not specific time periods, Equation (28) simplifies to
𝑁−1
var(𝑟) 2
var(𝜇 ) = [1 + ∑(𝑁 − 𝑘)𝜌(𝑘)]. (29)
𝑁 𝑁
𝑘=1

The correlation 𝜌(𝑘) denotes correlation between any pair of return vectors with lag k
among them. If k equals one, there are 2(𝑁 − 1) such pairs. If k is (𝑁 − 1), however, there
are only 2 pairs. Thus, a weighted sum of correlations of all possible lags would determine

12
whether the impact of cross-sectional correlations contributes positively (negatively) to
Equation (29), leading to positive (negative) contribution to return effect and negative
(positive) effect to rebalancing alpha.

R EBALANCING ALPHA – LONG - ONLY PORTFOLIOS

We now combine the results of both the volatility and return effects to derive
approximation of rebalancing alpha. As in the previous analysis, we first gain insights by
examining the case of two-asset portfolios.

The two-asset case

According to Equation (8), (15), (21), and (22), we have

1 2
(𝑁 − 1)
𝛼PR = 𝑔FW − 𝑔BH = 𝑒𝑣 − 𝑒𝑟 ≈ 𝑒̃𝑣 − 𝑒̃𝑟 = 𝑤1 𝑤2 𝜎1_2 − 𝑤1 𝑤2 (𝑔1 − 𝑔2 )2 . (30)
2 2

Factoring the portfolio weights and the variance term leads to

2
1 2 √𝑁 − 1(𝑔1 − 𝑔2 ) 1 2 2
𝛼PR ≈ α
̃PR = 𝑤1 𝑤2 𝜎1_2 {1 − [ ] } = 𝑤1 𝑤2 𝜎1_2 (1 − 𝑡1_2 ). (31)
2 𝜎1_2 2

We have identified the term inside the bracket as the “t-statistics” of relative return
difference between the two assetsIII. It is not exactly the conventional t-stat since we have
geometric means rather than arithmetic means. However, in cases where the variances of
both assets are the same or small relative to the arithmetic means, the geometric means are
roughly the same as the arithmetic means by the formula (10).

Equation (31) is a succinct and important result. It is worth exploring its full implications.
First, for long-only portfolios, since the weights are positive the sign of rebalancing 𝛼PR
2
depends on the magnitude of 𝑡1_2 . When the absolute value of the t-stat is less than one
rebalancing alpha is positive, and when the absolute value of t-stat is greater than one,
rebalancing alpha is negative. When the t-stat is zero, i.e., the two assets have the same
sample geometric returns, the value added of portfolio rebalancing is the highest. In other
words, if there was no eventual winner or loser, then selling temporary winners and buying
temporary loser yields the most alpha possible.

13
Secondly, suppose one of the two assets is the risk-free asset, then the t-stat becomes the
term √𝑁 − 1 times the familiar Sharpe ratio of the risky asset. It is in fact the t-stat for the
positive excess return of the risky asset. While t-stat of two is normally the threshold of
statistical significance for the excess return, t-stat of one is sufficient for the BH portfolio to
outperform the FW portfolio.

Third, Equation (31) can also be used to estimate the probability of positive rebalancing
alpha given assumptions of means and volatilities of asset returns. For instance, suppose
the two assets have the same expectation in g. Then, 𝑡1_2 is approximately a random
variable of t-distribution with 𝑁 − 1 degree of freedom. The probability of 𝛼PR > 0 is the
cumulative probability of |𝑡1_2 | < 1. For example, if 𝑁 = 5, i.e., the number of periods is 5,
the probability of 𝛼PR > 0 is about 63%. If 𝑁 = 10 the probability increases slightly to
66%IV, or a chance of 2 out 3.

Fourth, other factors in Equation (31) have direct impact on the size of the rebalancing
alpha, not on the sign. The rebalancing alpha is directly proportional to the variance of
return differencesV. Of course, this linear relationship works both ways: when the
rebalancing alpha is either positive or negative.

Fifth, the rebalancing alpha does not depend explicitly on mean-reversion of asset returns.
Of course, mean reversion would lessen return effect so it implicitly contributes to
rebalancing alpha. It remains to be seen whether rebalancing alpha can be positive if the
net effect of serial correlations is zero (Qian 2104b). Lastly, the product of the two weights
varies between the minimum value of zero (when one asset weight is zero) and the
maximum value of 0.25 (when the two weights are equal and at 0.5). Therefore, an equally
weighted portfolio is the one that achieves either maximum positive rebalancing alpha or
minimum negative rebalancing alpha. Numerically, if the t-stat in Equation (31) is zero, the
weights are 50/50, and the volatility of return differential is 20%, then the rebalancing
return is 50 basis points, or 0.5% [=0.5*0.5*0.5*(0.2)2].

Example of two-asset cases

14
Our first empirical example consists of asset allocation portfolios. We use them to provide
further understanding of both magnitude and accuracy of Equation (31), as well as the
accuracy of volatility and return effects separately. We shall use asset allocation portfolios
consisted of cash, US Treasury bonds and US stocks for this purpose. They are represented
by the 3-month US Treasury bill index, the Barclays Aggregated US Treasury index, and the
S&P 500 total return index and their annual total returns are from 1990 to 2013VI. Exhibit
1 displays the annual geometric returns, the annual return volatilities, and Sharpe ratios of
bonds and stocks.

Exhibit 1 Return statistics of three asset classes

Cash UST S&P 500 S&P500/UST

Geometric Return 3.29% 6.26% 9.45% 3.20%
Annual Volatility 2.33% 6.12% 18.64% 20.95%
Sharpe Ratio 0.48 0.33 0.15
t-statistics 2.33 1.59 0.73

The S&P 500 index had a Sharpe ratio of 0.33. For this period of 24 years, the t-stat is about
1.59, which is greater than one. Thus, a BH portfolio invested in any non-trivial
combination of the S&P 500 index and cash at the beginning of 1990 would have
outperformed its FW counterpart from 1990 to 2013. In other words, the rebalancing alpha
would be negative based on this approximation. The same is true for any non-trivial
portfolios of the US Treasury bonds and cash, since the US Treasury index had a Sharpe
that is even higher, at 0.48. In both of these cases, the risky assets (stocks or bonds) had
returns that were substantially higher than the cash return. Portfolio rebalancing in any
stock/cash or bond/cash portfolios would yield lower returns than the BH portfolios.

However, a stock/bond portfolio over the same period would be different. Exhibit 1 (the
last column) shows the difference of geometric return between stocks and bonds is 3.20%
and the volatility of return difference is 20.95%. The ratio of two is just 0.15 with a t-stat of
0.73, which is less than one. Consequently, portfolio rebalancing for any non-trivial
stock/bond portfolio would have positive alpha for this period. Fundamentally, the excess
return of stocks over bonds, at 3.20% is lower than historical average and as a result, the

15
return effect is not high enough to offset the strong volatility effect of portfolio rebalancing,
which has been enhanced by the correlation of -0.24 between the two asset classes.

The question of portfolio rebalancing between stocks, bonds, and cash often evokes strong
and opposite reactions among practitioners, due to their ubiquitous and significant roles in
asset allocation portfolios as well as seemingly different results regarding rebalancing
alpha derived from different portfolio contexts and/or different time periods. Our analysis
provides insights as to why rebalancing alpha is positive for stock/bond portfolios but
negative for stock/cash and bond/cash portfolios.

We should emphasize that the example above is specific to the period and it does not imply
that rebalancing a stock/bond portfolio always add value. Over time, it is likely the
opposite is true, provided the excess return of stocks over bonds is sufficiently high and
resilient.

It is noteworthy to make a further remark on the stock/bond example. One could

reasonably argue that the low excess return of stocks over bonds in the recent years was
due to the strong performance of US Treasuries because their yields have dropped
significantly over time as inflation declined and economic growth slowed. Indeed, a Sharpe
ratio of 0.48 is high for US Treasuries, compared with historical average while a Sharpe
ratio of 0.33 for stocks is in line with historical average. Suppose we assume bonds had a
Sharpe ratio of 0.33 as well, with other return measures unchanged, we can use Equation
(31) to analyze possible outcomes of rebalancing alpha.

A Sharpe ratio of 0.33 for bonds implies a return premium of 2.02% [=0.33*6.12%] over
cash. Since equity’s return premium over cash is 6.16% [9.45% - 3.29%], the excess return
of stocks over bonds increases to 4.14% [=6.16% - 2.02%]. This yields a return/risk ratio of
0.20 = [4.14%/20.95%]. Assuming these values are again achieved over a period of 24
years, then the t-stat equals to 0.96 [=0.20*√23], which is still slightly less than one. In
other words, if the bonds had performed similarly to stocks in terms of risk-adjusted
return, the portfolio rebalancing would still have had a positive, albeit negligibly small
alpha.

16
However, if these return and risk measures could be sustained over 50 years, then the t-
stat would be 1.4 instead, which is higher than one. As a result, the rebalancing alpha would
turn quite negative, indicating FW portfolios delivering lower returns than BH portfolios.
This should not be too surprising because, if the excess return of stocks over bonds is
positive over a very long period of time, then the portfolio weight of stocks would increase
substantially in a BH portfolio while its FW counterpart maintains a constant weight.
Provided stocks continuing to outperform bonds, the BH portfolio would have higher
returns in the end. However, it would definitely have much higher risks than the FW
portfolio as well, due to its high stock weights.

Of course, this long run outperformance of BH portfolio is neither guaranteed nor without
drawbacks. We have just noted that even if stocks outperformed bonds by over 4% per
year over a period of 24 years, buy-and-hold might still lose out. In addition, on a risk-
adjusted basis, the BH portfolio would still be inferior to the FW portfolio even if they do
have higher returns (Qian, 2014a). We emphasize that when a BH portfolio becomes
dramatically different from its initial portfolio due to return drifts, it is no longer
appropriate to compare it to the FW portfolio only on return basis. One must also consider
the difference of portfolio risks.

Continuing with the stock/bond example, we now examine separately the accuracy of
approximations for volatility and return effects, and rebalancing alpha. For an initial
portfolio of given weights, we calculate actual return differences between FW portfolio, BH
portfolio and geometric average of returns (𝑒𝑣 = 𝑔FW − 𝑔̅ , 𝑒𝑟 = 𝑔BH − 𝑔̅ ) and rebalancing
alpha (𝛼PR = 𝑔FW − 𝑔BH ). We then calculate the approximations to these measures
(𝑒̃𝑣 , 𝑒̃𝑟 , α
̃PR ) for comparison, based on the analytic approximation.

17
Exhibit 2(a) The geometric return of FW portfolios (𝒈𝐅𝐖 ), BH portfolios (𝒈𝐁𝐇 ) and the weighted averages of

̅)
geometric return (𝒈

10.0%

9.5%

9.0% FW Return

BH Return
8.5%
Average
8.0% Return

7.5%

7.0%

6.5%

6.0%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Bond Weight

Exhibit 2(a) are the actual geometric returns of FW and BH portfolios, as well as the
weighted averages of stocks’ and bonds’ geometric returns, as functions of initial portfolio
weight in bonds. Since stocks had a higher return than bonds, all three measures decline as
the weight of bonds increases from 0% to 100%. In addition, we note both FW and BH
returns are higher than the weighted average, indicating both volatility and return effects
are positive. Consistent with our analysis of “t-stat”, the FW return is the highest among the
three so the rebalancing alpha is always positive.

We show the difference between the FW return and the weighted average, i.e. the volatility
effect, in Exhibit 2(b). It ranges from zero (when the weight of bonds is either 0% or 100%)
to about 56 basis points (when the portfolio is roughly 50/50). The dashed line,
representing the approximation, is very close to the actual values. However, we note the
accuracy is better when the bond weight exceeds 50%.

18
Exhibit 2(b) The volatility effect and its approximation for the stock/bond portfolios

0.60%

0.50%

0.40%

0.30% Volatility Effect

ev Approximation
0.20%

0.10%

0.00%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Bond Weight

We show the difference between the BH return and the weighted average, i.e. the return
effect, in Exhibit 2(c). It ranges from zero (when the weight of bonds is either 0% or 100%)
to about 26 basis points (when the bond weight is roughly 60%). The dashed line,
representing the approximation, is also close to the actual values. Similar to Exhibit 2(b),
the accuracy is better when the bond weight exceeds 50%.

Exhibit 2(c) The return effect and its approximation for the stock/bond portfolios

0.60%

0.50%
Return Effect
er Approximation
0.40%

0.30%

0.20%

0.10%

0.00%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Bond Weight

Finally, we show the difference between the FW return and BH return, i.e. the rebalancing
alpha, in Exhibit 2(d). It ranges from zero to about 30 basis points. It is quite noticeable that
the rebalancing alpha is not symmetric with respect to the bond weight. The maximum

19
alpha is near 40% in the bond weight while the approximation (the dashed line) has its
maximum at 50% as we discussed previously. The approximation and the actual alpha
again show a wider gap when the bond weight is less than 50%VII.

For long-only stock/bond portfolios considered here, the analytic approximation of

volatility and return effects and of rebalancing alpha appear to quite accurate.

Exhibit 2(d) The rebalancing alpha and its approximation for the stock/bond portfolios

0.60%

0.50%

Rebalancing Return
0.40%
alpha Approximation

0.30%

0.20%

0.10%

0.00%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Bond Weight

The general case

We now consider rebalancing alpha of a portfolio with M assets. Combining Equation (8),
(16), and (24), and factoring the common terms, we have a generalization of Equation (31)
𝑀 𝑀
1 2 2 1 2 2
𝛼PR ≈ α
̃PR = ∑ 𝑤𝑖 𝑤𝑗 [𝜎𝑖_𝑗 − (𝑁 − 1)(𝑔𝑖 − 𝑔𝑗 ) ] = ∑ 𝑤𝑖 𝑤𝑗 𝜎𝑖_𝑗 (1 − 𝑡𝑖_𝑗 ). (32)
2 2
𝑖<𝑗 𝑖<𝑗

Intuitively, rebalancing alpha of a portfolio is simply the sum of rebalancing alphas of all
distinct pairs. Notice that the portfolio weights are separable from the term that consists of
volatilities, investment returns, and investment horizon that are “intrinsic” to asset returns
and investment period. We have also written the rebalancing alpha in terms of t-stats of
individual pairs.

We make several remarks about this general result. First, rebalancing alpha for a long-only
portfolio will be positive if rebalancing alphas of all pairs are non-negative and there is at

20
least one positive pair. A special case in this regard, albeit a theoretically one, is when all
geometric returns are the same. Then the return effect vanishes and rebalancing alpha is
just the volatility effect. Second, suppose there are some pairs with negative rebalancing
alphas. If one can judiciously choose portfolio weights that exclude those pairs, it will lead
to a positive rebalancing alpha. Of course, this requires forecasting of pair-wise rebalancing
alpha which might be hard to do in reality. Third, we recall that in the two-asset case an
equally weighted portfolio gives extreme rebalancing alpha. There is a similar result in the
2 2
general case. It can be shown if the term [𝜎𝑖−𝑗 − (𝑁 − 1)(𝑔𝑖 − 𝑔𝑗 ) ] is the same for all pairs,

then an equally weighted portfolio achieves extreme rebalancing alpha, either positive or
negative.

Equation (32) has a succinct matrix form

1 ′
̃PR =
α ⃗⃗ [Σv − (𝑁 − 1)Σg ]𝑤
𝑤 ⃗⃗ . (33)
4

Note it is similar to variance of a portfolio in terms of the weight vector and a covariance
matrix. The difference is that in the case of rebalancing alpha, the matrix is not covariance
matrix. Rather, it is a linear combination of “distance matrices” between distinct pairs. They
are not necessarily positive definite like covariance matrices.VIII.

There is an alternative expression of rebalancing alpha of a portfolio in terms of

rebalancing alphas of individual assets versus the FW portfolio. Since we are not going to
rely on it in the remainder of the paper, we relegate it to an appendix.

Example of general cases – sector portfolios

Our second empirical example concerns equity portfolios with sector allocations. We use
ten sectors in the S&P 500 index to build portfolios and compare the performance of FW
portfolios and BH portfolios. As we have shown above, portfolio rebalancing alpha depends
on the pairwise rebalancing alphas of the ten sectors and initial portfolio weights.
Therefore, the first step is to analyze returns and risks of all distinct sector pairs.

Exhibit 3 displays geometric return, volatility and Sharpe ratio of the 10 S&P 500 index
sectors based on annual returns from 1990 to 2013. The returns fall roughly into 3 groups.

21
The first group of six sectors has returns between 10% and 12%; the second group of three
sectors has returns between 7% and 8%; the last group is the telecommunication sector
with the lowest return of 5.7%. The volatilities have a wider range, with financials and
technology having the highest risks and consumer staples and energy having the lowest
risk.

Exhibit 3 Annual return statistics of ten S&P 500 sectors from 1990 to 2013

Return Volatility Sharpe Ratio

Consumer Staples (CSS) 11.12% 14.78% 0.53
Consumer Discretionary (CSD) 10.36% 22.73% 0.31
Energy (ENE) 11.50% 16.64% 0.49
Financials (FIN) 8.41% 25.93% 0.20
Health Care (HLT) 11.62% 23.05% 0.36
Industrials (IND) 10.07% 19.24% 0.35
Information Technology (TEC) 10.58% 32.94% 0.22
Materials (MAT) 8.19% 19.49% 0.25
Telecommunication Services (TEL) 5.71% 23.29% 0.10
Utilities (UTL) 7.45% 20.70% 0.20

For each pair, we calculate the difference of their geometric returns from Exhibit 3 and
pairwise volatilities of their return differences based on historical returns. These measures
serve as the basis for calculating volatility and return effects of each pair. We list them in
two separate matrices in an appendix. In Exhibit 4, we display the combined effect in terms
of the t-stat of all pairs in a matrix form. The element in i-th row and j-th column is
simply √23(𝑔𝑖 − 𝑔𝑗 )/𝜎𝑖_𝑗 . If the t-stat is between minus one and one, then the rebalancing
alpha is positive for the pair. If the t-stat is greater than one or less than minus one the
rebalancing alpha is negative for the pair. Even though the matrix is anti-symmetric, only
the magnitude of the matrix elements is relevant to rebalancing alpha.

Out of 45 distinct pairs, 9 has negative rebalancing alpha, one has zero alpha (telecom and
technology), and 35 has positive alpha. The 9 pairs with negative alpha mostly are between
sectors with the highest returns (consumer staples and discretionary, energy, health care,
and industrials) and sectors with the lowest returns (telecom and utilities). Note even
though the technology sector’s return is relatively high it does generate negative
rebalancing alpha with any other sectors. This is because its volatility at almost 33%

22
induces significant positive volatility effects in pairwise rebalancing that are higher than
return effects.

In addition to the small portion of pairs with negative rebalancing alphas, the magnitudes
of those negative alphas are also relatively small compared to magnitudes of positive
alphas. This can be seen from the fact that the t-stats of negative pairs are close to either
one or minus one but the t-stats of many positive pairs are rather small in terms of their
magnitudes. For a long-only portfolio composed of these ten sectors, its rebalancing alpha
is a weighted sum of these pairwise rebalancing alphas. One would suspect that it is highly
likely its rebalancing alpha will be positive.

Exhibit 4 The pairwise t-stats [𝒕𝒊−𝒋 ] of return differences between distinct sector pairs. Those above 1 or below -1
are in red indicating potential negative rebalancing alpha for the pair; other pairs have t-stat between -1 and 1
indicating positive rebalancing alpha

CSS CSD ENE FIN HLT IND TEC MAT TEL UTL
CSS 0.18 -0.11 0.71 -0.20 0.34 0.08 0.71 1.21 1.10
CSD -0.18 -0.25 0.51 -0.26 0.10 -0.05 0.65 1.38 0.56
ENE 0.11 0.25 0.71 -0.03 0.56 0.15 1.05 1.32 1.28
FIN -0.71 -0.51 -0.71 -0.80 -0.58 -0.33 0.05 0.54 0.22
HLT 0.20 0.26 0.03 0.80 0.39 0.15 0.63 1.14 1.10
IND -0.34 -0.10 -0.56 0.58 -0.39 -0.10 0.74 1.19 0.71
TEC -0.08 0.05 -0.15 0.33 -0.15 0.10 0.45 1.00 0.43
MAT -0.71 -0.65 -1.05 -0.05 -0.63 -0.74 -0.45 0.54 0.15
TEL -1.21 -1.38 -1.32 -0.54 -1.14 -1.19 -1.00 -0.54 -0.33
UTL -1.10 -0.56 -1.28 -0.22 -1.10 -0.71 -0.43 -0.15 0.33

We shall not evaluate the accuracy of analytic approximations of volatility and return
effects and rebalancing alpha of 45 individual pairs. Instead, we evaluate the accuracy of
approximations for a multitude of portfolios. An obvious choice is the equal-weighted
portfolio. We display the results in Exhibit 5. First, the average of geometric returns is
9.50% and both FW and BH portfolios’ returns are higher, with the FW portfolio returns
10.44% and the BH portfolio returns 9.83%. This is a positive rebalancing alpha of 0.60%.
The analytical approximation yields a volatility effect of 1.05% versus the actual value of
0.94% (=10.44% - 9.50%). The approximation of the return effect is 0.40% and the actual

23
value of 0.33% (=9.83% - 9.50%). For the rebalancing alpha, the estimate is 0.65% with an
error of 0.05%.

Exhibit 5 Actual and approximated geometric returns of equal-weighted FW and BH portfolios, and associated
volatility effect, return effect, and rebalancing alpha.

𝒈𝐅𝐖 𝒈𝐁𝐇 ̅
𝒈 𝒆𝒗 𝒆𝒓 𝜶𝐏𝐑
Actual 10.44% 9.83% 9.50% 0.94% 0.33% 0.60%
Approximation 10.56% 9.90% - 1.05% 0.40% 0.65%
Error 0.12% 0.07% - 0.12% 0.07% 0.05%

The example of equal-weighted portfolio demonstrates the approximations are reasonably

accurate. To evaluate the accuracy for a general long-only portfolio, we randomly simulate
10,000 initial portfoliosIX and then follow the resulting 10,000 BH and 10,000 FW
portfolios over the course of 24 years based on realized sector returns. To check the
accuracy of analytic results, we compare the actual rebalancing alpha 𝛼PR = 𝑔FW − 𝑔BH and
the approximated alpha α
̃PR based on Equation (32) or (33).

Exhibit 6 Scatter plot of rebalancing alphas and their approximations for the 10,000 random simulated
portfolios. The solid line is the line when there is no error.

1.2%

1.0%
Alpha Approximation

0.8%

0.6%

0.4%

0.2%

0.0%
0.0% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2%
Rabalacing Alpha

Exhibit 6 shows the scatter plots of 10,000 points representing actual and approximated
rebalancing alphas for 10,000 portfolios. The red line is the line where two are equal, i.e.
̃PR = 𝛼PR . The vertical distance from each point to this line is the error of the
α
approximation. First, we notice the errors are systematically positive when the rebalancing

24
alpha is high while they are systematically negative when the rebalancing alpha is low. This
is mainly due to the overestimation of volatility effect when the rebalancing alpha is high,
which could be the result of high portfolio volatility. As we indicated before, the estimated
volatility effect is vulnerable if portfolio volatility or sector volatilities are high.

Second, we note the absolute errors are reasonable small despite the observed tilt. Out of
10,000 portfolios, the maximum error is 17 bps, while the average error is 5 bps. A linear
regression of approximation against the true alpha has a R-square of 98%.

Lastly, the rebalancing alphas for 10,000 portfolios are all positive, ranging from 12 bps to
109 bps. This extraordinary result is a manifestation of the fact that a majority of pairwise
alphas is positive and none of our randomly simulated portfolios is concentrated in those
negative pairs. However, what is not true is all sector portfolios would have a positive
rebalancing alpha. We can easily identify a portfolio with negative rebalancing alpha by
choosing in Exhibit 4 a pair with the t-stats above one. For example, a 50/50 portfolio in
consumer discretionary and telecommunication has a rebalancing alpha of negative 30 bps.
Nevertheless, the probability of negative rebalancing alpha for a diversified sector portfolio
is extremely rare.

Cross-sectional serial correlations of sector portfolios

Why the sector returns from this period are so overwhelmingly favorable to FW portfolios?
There could only be two reasons: high volatility effects and/or low return effects. An
analysis of cross-sectional serial correlations shows they had a significant impact in
lowering the return effects of portfolio rebalancing, resulting in positive rebalancing alpha.

We study the impact of serial correlations using Equation (29), which gives an approximate
relationship between serial correlations of all lags and the variance of arithmetic means.
Equation (29) is valid for any portfolios, whose sector weights serve as weights in the
variance calculation. For brevity, we show the results for one specific portfolio – the equal-
weight portfolio.

Exhibit 7 displays the average cross-sectional serial correlations of annual returns over the
period from 1990 to 2013 as well as their scaled contribution to the overall variance of

25
arithmetic means. The scaling factors given in Equation (29) is 2(𝑁 − 𝑘)/𝑁 with k being
the lag.

We make several observations. First, the average serial correlation with one lag is positive.
This is consistent with a 12-month cross-sectional sector momentum, a part of equity
momentum phenomenon. However, from lag 2 to lag 10, the correlations are mostly
negative, indicating return reversal at between 2 years and 10 years. Beyond 10 years, the
correlations seem to alter signs frequently and randomly. Second, the contribution of each
lagged correlation varies. When the lag is short, the contribution is magnified since there
are more sub-periods with short lags. When the lag is long, the contribution is reduced
since there are few sub-periods with long lags. As a result, the correlations with lags
beyond 15 years have their contributions scaled down while the contributions within 9
years scaled up.

Exhibit 7 Average equal-weighted cross-sectional serial correlation of sector returns for different lags and their
contribution to the variance of arithmetic means

0.50

0.40
Lagged Correlation
0.30
Scaled Contribution
0.20

0.10

0.00

-0.10

-0.20

-0.30
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23
Lag

The sum of all contributions gives rise to the summation term in Equation (29), which
measures the overall rise or fall in the variance of arithmetic means caused by cross-
sectional serial correlation. In Exhibit 8, we plot the cumulative sum as a function of lags
included. We note the sum is positive up to lag 4 due to the lingering effect of 12-month
momentum. It turns negative at lag 5 and then declines sharply from lag 6 to lag 9 as the
correlations and contributions from those lags are significantly negative. As the lag

26
increases more, the cumulative sum settles down and fluctuates around -0.6. From
Equation (30), this implies a 60% reduction in the variance of arithmetic means relative to
a hypothetical case in which the sector returns are serially uncorrelated. Another
observation from Exhibit 8 is this level of reduction is achieved when the lag gets to 8 years
and beyond. This strongly implies that significant reduction in return effect with horizon
beyond 8 years and perhaps high probability of positive rebalancing alpha for those
horizons. On the other hand, when the horizon is much shorter, the probability of positive
rebalancing will be much smaller.

Exhibit 8 Cumulative contributions of cross-sectional serial correlations to the variance reduction of arithmetic
means

0.20

0.00

-0.20

-0.40

-0.60

-0.80

-1.00
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23
Lag

R EBALANCING ALPHA OF LONG - SHORT PORTFOLIOS

Long-short portfolios have negative portfolio weights and portfolio leverage. Leverage is as
old as credits in an economy; investors have always employed it in one form or another.
The examples range from simply buying stocks on margin, to many alternative
investments, such as private equity (leveraged buyout), real estate (mortgages), and hedge
funds that institutional investors and high-net-worth individuals have come to embrace as
parts of their investment portfolios. Some of the most recent variants are 130/30 equity
portfolios from several years ago, Risk Parity portfolios with a balanced risk allocation to
various risk premiums, and proliferating leveraged ETFs.

27
One of new features of these new long-short portfolios is they all adhere to a portfolio
rebalancing approach, either to maintain a fixed-weight portfolio or a fixed-risk portfolio in
the case of Risk Parity. Thus, it is important to know whether portfolio rebalancing of long-
short portfolios has rebalancing alpha. A more basic question is how and why portfolio
rebalancing of long-short portfolios is different from portfolio rebalancing of long-only
portfolios.

In an earlier paper (Qian 2012), the author analyzed the volatility effect of long-short
portfolios, based on the same formula derived previously and presented in the present
paper [Equation (14) and (16)]. It is found that on a total portfolio level, the act of
rebalancing amounts to deleveraging when there are losses and re-leveraging when there
are gains. In other words, it is buy high and sell low. This produces a negative volatility
effect. However, among different asset classes within the portfolio, portfolio rebalancing
still preserves and to some degree magnifies its original long-only positive volatility effect.
The net result of the two effects then determines the overall volatility effect of a long-short
portfolio. One implication of this result is that volatility effects of long-short portfolios are
no longer always positiveX.

What happens to return effects of long-short portfolios? Could it now also turn positive for
some long-short portfolios? In other words, could the geometric mean of a BH long-short
portfolio be lower than the weighted average of geometric means? The answer is yes. We
have already seen this in the two-asset case [Equation (22)] in our analysis. In a recent
paper (Qian 2014a), it is shown that for some types of long-short portfolios, the expected
terminal wealth of BH portfolios is less than the expected terminal wealth of FW portfolios.
The same analysis would also show these long-short portfolios have negative return
effects.

Thus, the picture of volatility and return effects and that of rebalancing alpha of long-short
portfolios are much less clear than that of long-only portfolios. In the case of long-only
portfolios, many classical mathematical tools, such as Jensen’s inequality and GM-AM
inequalityXI, as well as analytic approximations based on Taylor expansion readily apply.
The land of long-short portfolios seems much more unruly. It is beyond the scope of this

28
paper to have a full exploration. Here we shall focus on one type of long-short portfolios
and present an alternative approximation to the return effect of these portfolios. This
approximation is different from the one we have presented previously for long-only
portfolios. It is necessary since the new approximation proves to be more accurate.

The return effect of long-short portfolios

We first consider a two-asset long-short portfolio. Without loss of generality, we assume

𝑤1 < 0, 𝑤2 > 0 and 𝑤1 + 𝑤2 = 1. We are concerned with the difference between geometric
return of the BH portfolio and weighted average of geometric returns of the two assets.
Equation (4) reduces to (1 + 𝑔BH )𝑁 = 𝑤1 (1 + 𝑔1 )𝑁 + 𝑤2 (1 + 𝑔2 )𝑁 . Equation (5) is simply
𝑔̅ = 𝑤1 𝑔1 + 𝑤2 𝑔2 .

There are two crucial differences between the long-short case and the long-only case when
it comes to two-asset portfolios. First, the return 𝑔BH will be less than 𝑔̅ . This is because in
this case the opposite of Jensen’s inequality is true (Bullen 2009, Qian 2014a). Hence, the
return effect 𝑒𝑟 = 𝑔BH − 𝑔̅ is negative instead of being positive. The second difference,
which is closely related to the first, is the “average” 𝑔̅ now falls outside of the interval
formed by 𝑔1 and 𝑔2 . It can be shown easily that in the case of 𝑤1 < 0, if 𝑔1 < 𝑔2 then
𝑔1 < 𝑔2 < 𝑔̅ and if 𝑔2 < 𝑔1 then 𝑔̅ < 𝑔2 < 𝑔1.

This “odd” weighted average leads to some strange phenomena that are not present in the
long-only case. First, the weighted “variance” [Equation (22)] var(𝑔) = 𝑤1 𝑤2 (𝑔1 − 𝑔2 )2 is
negative. Second, this variance can be very large in magnitude compared to the difference
between the two means. Consequently, the approximation to the return effect using Taylor
expansion around 𝑔̅ is no longer valid and we need to find an alternative approximation.

In an appendix, we drive the alternative approximation. We have

1 + 𝑔2 𝑁−2 (𝑁 − 1)
𝑒̃𝑟,𝐿𝑆 = ( ) var(𝑔) = 𝑘𝐿𝑆 𝑒̃𝑟 . (34)
1 + 𝑔̅ 2(1 + 𝑔̅ )

Comparing it to the result for a long-only portfolio of Equation (22), we note the difference
is a scaling factor

29
 1 + 𝑔2 𝑁−2
𝑘𝐿𝑆 =( ) . (35)
1 + 𝑔̅

The scaling factor is greater than one if 𝑔2 < 𝑔1because we have 𝑔̅ < 𝑔2, and is less than
one if 𝑔1 < 𝑔2 because we have 𝑔2 < 𝑔̅ . We note that this scaling factor depends on the
portfolio weights through 𝑔̅ . Thus even though it is a better approximation (as we shall
demonstrate in an example shortly), its expression has lost some of the elegance of the
original approximation, in terms of quadratic dependence of portfolio weights and the
separability of weights and returns.

This result can be generalized to long-short portfolios of more than two assets. The general
result is
𝑁−2
(1 + 𝑔̅𝑝 ) (𝑁 − 1)
𝑒̃𝑟,𝐿𝑆 = var(𝑔). (36)
(1 + 𝑔̅ )𝑁−2 2(1 + 𝑔̅ )

In the equation, 𝑔̅𝑝 is the weighted average of geometric means of long assets (see
appendix).

A Risk Parity example

Traditional asset allocation portfolios with capital allocation can be extremely non-
diversified even though their capital allocations look quite balanced. For instance, a 60/40
portfolio with 60% in equities and 40% in bonds is highly concentrated in equity risk since
equity returns are much more volatile than bond returns. Risk Parity, as a general
investment approach, uses risk allocation as the guiding principle of portfolio construction.
With prescribed risk allocation and total portfolio risk for a chosen risk measure, one can
derive the desired portfolio notional allocation (Qian 2005, 2006).

We construct simple Risk Parity portfolios using the US Treasury index and the S&P 500
index discussed in the previous example. Since the volatility ratio of the two asset classes is
roughly 1:3, the ratio of notional exposures of bonds versus stocks is 3:1 for Risk ParityXII.
When the portfolio is not leveraged, it is a 25/75 portfolio with 25% in the S&P 500 index
and 75% in the US Treasury index. With leverage, a short position in cash is introduced.
However, the ratio of notional exposures of bonds and equities remains 3:1. For example,

30
when the leverage reaches 200%, the notional exposures would be 150%, 50%, and -100%
for bonds, equities, and cash respectively.

We study volatility effect, return effect, and rebalancing alpha of these Risk Parity
portfolios as we dial up the portfolio leverage from 100% to 200%. In particular, the return
effect of portfolio rebalancing warrants more attention since these are long-short
portfolios. We will compare two approximations of the return effect and show the
alternative approximation of Equation (34) is more accurate. The empirical analysis
follows a similar line laid out in the previous two-asset stock/bond example.

Exhibit 9 plots the returns of FW and BH portfolio as the leverage increases from 100% to
200%. When the portfolio is long-only, i.e., leverage at 100%, both FW and BH returns are
higher than the average return. However, as the leverage increases, the FW return keeps up
with the average return and the volatility effect stays positive. This indicates the positive
volatility effect between equities and bonds is greater than the negative volatility effect
associated with the leverage. In contrast, the BH return lags the other two. It falls below the
average return when the leverage reaches around 120%. In other words, the return effect
turns negative, which never happens for long-only portfolios. When the leverage reaches
200%, the BH return is substantially lower than the FW return. This should not be too
surprising. As equities and bonds both outperformed cash, the BH portfolios’ leverage
declines steadily without rebalancing, resulting in lower returns.

31
Exhibit 9 The return of FW and BH Risk Parity portfolios and the average geometric return for varying degree of
portfolio leverage

12%

11% FW return
BH Return
10% Average Return

9%

8%

7%

6%
100% 110% 120% 130% 140% 150% 160% 170% 180% 190% 200%
Leverage

The difference between the FW return and the weighted average of geometric return is the
volatility effect. We plot it in Exhibit 10, along with the approximation based on the
difference between portfolio variance and weighted average of individual variances. The
approximation is excellent when the leverage is low. However, as the leverage increases,
the gap widens between the two as the approximation of volatility effect becomes less
accurate. However, the error is only about 10 bps at 200% leverage.

Exhibit 10 The volatility effect and its approximation of Risk Parity portfolios

0.65%

0.60%

Volatility Effect
0.55% Ev approximation

0.50%

0.45%

0.40%
100% 110% 120% 130% 140% 150% 160% 170% 180% 190% 200%
Leverage

32
The approximation of return effect presents a bigger challenge. Exhibit 11 displays the
return effects of the Risk Parity portfolios and the original approximation and the
alternative approximation. The original approximation deteriorates rapidly as the leverage
increases. It overestimates the negative effect by over 100 basis points when the leverage
reaches 200%. The alterative approximation shows significant improvement. It is close to
the actual value and the error is only about 25 basis points when the leverage is 200%.
Compared to the volatility effect, the approximations of return effects is less accurate.

Exhibit 11 The return effect and two approximations of Risk Parity portfolios

0.5%

0.0%

-0.5%

-1.0% Return Effect

Er approximation
Er LS approximation
-1.5%

-2.0%

-2.5%

-3.0%
100% 110% 120% 130% 140% 150% 160% 170% 180% 190% 200%
Leverage

The volatility effect increases with the leverage and the return effect decreases with
leverage. The combined effect is rebalancing alpha increases monotonically. In Exhibit 12,
we show the actual rebalancing alpha and the two approximations. The original
approximation over-estimates the alpha significantly while the alternative approximation
is much closer to the actual value. The results show the improvement of alternative
approximation of return effect for long-short portfolios is crucial to the approximation of
rebalancing alpha of long-short portfolios.

33
Exhibit 12 The rebalancing alpha and two approximations of Risk Parity portfolios

3.5%

3.0%

2.5%
Rebalancing Alpha
Alpha Approximation LS
2.0%
Alpha Approximation

1.5%

1.0%

0.5%

0.0%
100% 110% 120% 130% 140% 150% 160% 170% 180% 190% 200%
Leverage

C ONCLUSION

In this paper, we have analyzed rebalancing alpha of FW portfolios versus BH portfolios. In

particular, we have shown the crucial relationship between rebalancing alpha and pairwise
return variances and pairwise return differences. It is established that in long-only
portfolios with two assets, the rebalancing alpha is proportional to t-statistics of excess
returns between the two assets. In the general case, the results can be succinctly
summarized by a quadratic form of portfolio weights and pairwise variance and return
matrices. We have also derived analytic result on the impact of cross sectional serial
correlations on the return effect of portfolio rebalancing.

Empirical examples in asset allocation portfolios, including both traditional long-only and
leveraged Risk Parity portfolio, and in equity sector portfolio demonstrate the results are
quite accurate. More importantly, our results have made the analysis of rebalancing alpha
more intuitive and tractable. We have also extended our analysis to long-short portfolios,
for which an alternative approximation of the return effect is presented.

The results are generic since they apply to both ex post analysis as well as ex ante
estimation. On the theoretical side, one can potentially derive optimal portfolio weights
that maximize rebalancing alpha. It remains to be seen whether portfolio rebalancing can

34
have positive alpha when all cross-sectional serial correlations are zero (Qian 2014b). On
the empirical side, our results provide an analytic framework to investigate rebalancing
alpha of portfolios of many other asset classes, such equity country and/or stock portfolios,
fixed income sector and country portfolios, and commodity portfolios.

A PPENDIX 1

We derive Equation (16) and (17) of volatility effect. Starting with Equation (14), we have

𝑀 𝑀 𝑀 𝑀 𝑀

2𝑒𝑣 ≈ ∑ 𝑤𝑖 σ2i − ∑ 𝑤𝑖 𝑤𝑗 𝜌𝑖,𝑗 σi σj = ∑ 𝑤𝑖 σ2i − ∑ wi2 σ2i − ∑ 𝑤𝑖 𝑤𝑗 𝜌𝑖,𝑗 σi σj

𝑖=1 𝑖,𝑗=1 𝑖=1 𝑖=1 𝑖≠𝑗
𝑀 𝑀 𝑀 𝑀 𝑀

= ∑ 𝑤𝑖 (1 − 𝑤𝑖 )σ2i − ∑ 𝑤𝑖 𝑤𝑗 𝜌𝑖,𝑗 σi σj = ∑ 𝑤𝑖 σ2i ∑ 𝑤𝑗 − 2 ∑ 𝑤𝑖 𝑤𝑗 𝜌𝑖,𝑗 σi σj . (A1)

𝑖=1 𝑖≠𝑗 𝑖=1 𝑗≠𝑖 𝑖<𝑗

In the last step, we have used the identity ∑𝑀

𝑖=1 𝑤𝑖 = 1. Now, the first term can be rewritten

as

𝑀 𝑀 𝑀

∑ 𝑤𝑖 σ2i ∑ 𝑤𝑗 = ∑ 𝑤𝑖 𝑤𝑗 (σ2i + σ2j ) . (A2)

𝑖=1 𝑗≠𝑖 𝑖<𝑗

Substituting it into (A1), we have

𝑀 𝑀
1 ′
2𝑒𝑣 ≈ ∑ 𝑤𝑖 𝑤𝑗 (σ2i + σ2j 2
− 2𝜌𝑖,𝑗 σi σj ) = ∑ 𝑤𝑖 𝑤𝑗 𝜎𝑖_𝑗 = 𝑤⃗⃗ Σv 𝑤
⃗⃗ . (A3)
2
𝑖<𝑗 𝑖<𝑗

Dividing both sides by 2 leads to Equation (14). The matrix symmetric Σv is

2
0 ⋯ 𝜎1_𝑀
Σv = ( ⋮ ⋱ ⋮ ). (A4)
2
𝜎𝑀_1 ⋯ 0

To derive Equation (17), we use Equation (13). Note

2
𝜎𝑖_FW = 𝜎𝑖2 + 𝜎FW
2
− 2cov(𝑟𝑖 , 𝑟FW ). (A5)

35
The last term is the covariance between asset I and the FW portfolio. Taking the weighted
average leads to

𝑀 𝑀 𝑀 𝑀

∑ 𝑤𝑖 σ2i_FW = ∑ 𝑤𝑖 σ2i + ∑ 𝑤𝑖 σ2FW − 2 ∑ 𝑤𝑖 cov(𝑟𝑖 , 𝑟FW ) . (A6)

𝑖=1 𝑖=1 𝑖=1 𝑖=1

The second term on the right is simply σ2FW . The third term can be summed as

𝑀 𝑀

−2 ∑ 𝑤𝑖 cov(𝑟𝑖 , 𝑟FW ) = −2cov (∑ 𝑤𝑖 𝑟𝑖 , 𝑟FW ) = −2cov(𝑟FW , 𝑟FW ) = −2σ2FW . (A7)

𝑖=1 𝑖=1

These results mean Equation (A6) becomes

𝑀 𝑀

∑ 𝑤𝑖 σ2i_FW = ∑ 𝑤𝑖 σ2i − σ2FW . (A8)

𝑖=1 𝑖=1

Substituting (A8) into Equation (13) gives Equation (17).

The matrix Σg in Equation (24) is

0 ⋯ (𝑔1 − 𝑔𝑀 )2
Σg = ( ⋮ ⋱ ⋮ ) (A9)
(𝑔𝑀 − 𝑔1 )2 ⋯ 0

Combining Equation (17) and (23), we can write rebalancing alpha as a weighted sum of
rebalancing alpha between all assets and the FW portfolio:

𝑀 𝑀
1 2
1 2 2
̃PR
α = ∑ 𝑤𝑖 [𝜎𝑖_FW − (𝑁 − 1)(𝑔𝑖 − 𝑔̅ )2 ] = ∑ 𝑤𝑖 𝜎𝑖_FW (1 − 𝑡𝑖_FW ). (A10)
2 2
𝑖=1 𝑖=1

A PPENDIX 2

Here we present the pairwise return and volatility of ten sectors. Exhibit 13 shows
pairwise return difference. Each number is the return of the row sector minus the return of
the column sector. The corresponding matrix is asymmetric.

36
Exhibit 13 Pairwise difference of geometric returns among ten sectors

CSS CSD ENE FIN HLT IND TEC MAT TEL UTL
CSS 0.00% 0.77% -0.38% 2.72% -0.50% 1.05% 0.54% 2.93% 5.41% 3.67%
CSD -0.77% 0.00% -1.14% 1.95% -1.27% 0.29% -0.22% 2.17% 4.64% 2.91%
ENE 0.38% 1.14% 0.00% 3.09% -0.12% 1.43% 0.92% 3.31% 5.79% 4.05%
FIN -2.72% -1.95% -3.09% 0.00% -3.22% -1.66% -2.17% 0.22% 2.69% 0.96%
HLT 0.50% 1.27% 0.12% 3.22% 0.00% 1.55% 1.04% 3.43% 5.91% 4.17%
IND -1.05% -0.29% -1.43% 1.66% -1.55% 0.00% -0.51% 1.88% 4.36% 2.62%
TEC -0.54% 0.22% -0.92% 2.17% -1.04% 0.51% 0.00% 2.39% 4.87% 3.13%
MAT -2.93% -2.17% -3.31% -0.22% -3.43% -1.88% -2.39% 0.00% 2.48% 0.74%
TEL -5.41% -4.64% -5.79% -2.69% -5.91% -4.36% -4.87% -2.48% 0.00% -1.74%
UTL -3.67% -2.91% -4.05% -0.96% -4.17% -2.62% -3.13% -0.74% 1.74% 0.00%

Exhibit 14 shows pairwise return volatility. The volatilities of return difference between
technology sector and many other sectors are high. On the other hand, industrial sector has
low return difference volatility with other sectors. The lowest pairwise volatility is
between healthcare and consumer staples. The corresponding matrix is asymmetric.

Exhibit 14 Pairwise return volatility of return difference among ten sectors

CSS CSD ENE FIN HLT IND TEC MAT TEL UTL
CSS 0.0% 20.4% 16.0% 18.2% 11.7% 14.9% 32.3% 19.8% 21.5% 16.0%
CSD 20.4% 0.0% 22.1% 18.4% 23.1% 13.1% 22.5% 16.0% 16.1% 25.1%
ENE 16.0% 22.1% 0.0% 20.9% 22.2% 12.2% 29.3% 15.1% 21.1% 15.2%
FIN 18.2% 18.4% 20.9% 0.0% 19.3% 13.8% 31.9% 20.8% 23.7% 21.0%
HLT 11.7% 23.1% 22.2% 19.3% 0.0% 19.0% 32.3% 26.1% 24.9% 18.2%
IND 14.9% 13.1% 12.2% 13.8% 19.0% 0.0% 24.9% 12.3% 17.6% 17.6%
TEC 32.3% 22.5% 29.3% 31.9% 32.3% 24.9% 0.0% 25.5% 23.3% 35.0%
MAT 19.8% 16.0% 15.1% 20.8% 26.1% 12.3% 25.5% 0.0% 21.8% 24.0%
TEL 21.5% 16.1% 21.1% 23.7% 24.9% 17.6% 23.3% 21.8% 0.0% 25.1%
UTL 16.0% 25.1% 15.2% 21.0% 18.2% 17.6% 35.0% 24.0% 25.1% 0.0%

A PPENDIX 3

In this appendix, we drive an approximation to the return effect of long-short BH portfolios.

We first consider the two-asset case, in which 𝑤1 < 0, 𝑤2 > 0 and 𝑤1 + 𝑤2 = 1. The return
effect is negative which can be expressed as

𝑤1 (1 + 𝑔1 )𝑁 + 𝑤2 (1 + 𝑔2 )𝑁 = (1 + 𝑔̅ + 𝑒𝑟 )𝑁 . (A11)

37
Since 𝑔̅ is now outside of the interval formed by 𝑔1 and 𝑔2 , we may not expand the left hand
side of (A11) around 𝑔̅ . On the other hand, note that 𝑔2 is always between 𝑔1 and 𝑔̅ . It turns
out that 𝑔2 is the weighted average of the other two measures, with positive weights. We
have

𝑤1 1
𝑔2 = − 𝑔1 + 𝑔̅ ≜ 𝜔1 𝑔1 + 𝜔
̅𝑔̅ . (A12)
𝑤2 𝑤2

In equation (A12), we have defined the new weights 𝜔1and 𝜔

̅. They are both positive and
sum to one. The variance based on these weights with respect to 𝑔2 is then positive. We
have

𝑤1 1
var(𝑔2 ) = − (𝑔1 − 𝑔2 )2 + (𝑔̅ − 𝑔2 )2 = −𝑤1 (𝑔1 − 𝑔2 )2 . (A13)
𝑤2 𝑤2

These properties imply that we can approximate the difference between 𝑔2 and the return
of an alternative BH portfolio with the weight 𝜔1in asset one and the weight 𝜔
̅ in the
original BH portfolio. The result is

𝑤1 1
− (1 + 𝑔1 )𝑁 + (1 + 𝑔̅ )𝑁 ≈ (1 + 𝑔2 + 𝑒̃𝑟2 )𝑁 . (A14)
𝑤2 𝑤2

We have defined

(𝑁 − 1) (𝑁 − 1)
𝑒̃𝑟2 = var(𝑔2 ) ≈ var(𝑔2 ). (A15)
2(1 + 𝑔2 ) 2

Note Equation (A14) and (A15) are entirely analogous to Equation (20) and (21). As we
have shown in the main text, they are valid approximations when the portfolio weights are
positive.

However, Equation (A15) is not yet the return effect of the original long-short portfolio
defined in Equation (A11). Now, by combining Equation (A14) and (A11) we derive an
approximation to 𝑒𝑟 in terms of 𝑒̃𝑟2. Multiplying Equation (A14) by 𝑤2 and expanding the
right hand side to the first two terms, we have

−𝑤1 (1 + 𝑔1 )𝑁 + (1 + 𝑔̅ )𝑁 ≈ 𝑤2 [(1 + 𝑔2 )𝑁 + 𝑁𝑒̃𝑟2 (1 + 𝑔2 )𝑁−1 ]. (A16)

38
Similarly, Equation (A11) is approximately

𝑤1 (1 + 𝑔1 )𝑁 + 𝑤2 (1 + 𝑔2 )𝑁 ≈ (1 + 𝑔̅ )𝑁 + 𝑁𝑒𝑟 (1 + 𝑔̅ )𝑁−1 . (A17)

Adding Equation (A16) and (A17) and rearranging terms, we have

(1 + 𝑔2 )𝑁−1 (1 + 𝑔2 )𝑁−2 (𝑁 − 1)
𝑒̃𝑟 ≈ − 𝑤 𝑒̃ = [−𝑤2 var(𝑔2 )]. (A18)
(1 + 𝑔̅ )𝑁−1 2 𝑟2 (1 + 𝑔̅ )𝑁−1 2

In the second expression, we have substituted Equation (A15) for 𝑒̃𝑟2. Using Equation
(A13) in (A18), we have

(1 + 𝑔2 )𝑁−2 (𝑁 − 1) 2]
(1 + 𝑔2 )𝑁−2 (𝑁 − 1)
𝑒̃𝑟 = [𝑤 𝑤 (𝑔
1 2 1 − 𝑔2 ) = [ var(𝑔)]. (A19)
(1 + 𝑔̅ )𝑁−1 2 (1 + 𝑔̅ )𝑁−2 2(1 + 𝑔̅ )

In the second expression, we have used the definition var(𝑔) – the weighted variance with
the original weights. We make several remarks about Equation (A19). First, the return
effect of a two-asset long-short portfolio is always negative. This is because one of the
weights must be negative. Second, we recognize the term in the bracket is of the same form
as the return effect of a long-only portfolio. Thus the return effect of the BH long-short
portfolio is obtained by scaling the formula for long-only return effect by a ratio of two
powers. The numerator is a power of the return of the long asset (asset 2 in our case) and
the denominator is a power of the average return.

For the general case with more than two assets, a similar approximation exists. We first
group assets into two groups: one with long assets and the other with short assets. Then
we calculate the average geometric mean of long assets by

1
𝑔̅𝑝 = ∑ 𝑤𝑖 𝑔𝑖 , with 𝑤𝑃 = ∑ 𝑤𝑖 . (A20)
𝑤𝑃
𝑤𝑖 ≥0 𝑤𝑖 ≥0

Then the return effect is simply

𝑁−2
(1 + 𝑔̅𝑝 ) (𝑁 − 1)
𝑒̃𝑟 = [ var(𝑔)]. (A21)
(1 + 𝑔̅ )𝑁−2 2(1 + 𝑔̅ )

39
The scaling ratio is a power of average mean of long assets over a power of the overall
mean. The variance in the bracket term is with respect to the original long and short
weights, which could be either positive or negative.

R EFERENCE

Bernstein, William J. and David Wilkinson, 1997. “Diversification, Rebalancing, and the
Geometric Mean Frontier.” Draft.

Booth, David G., and Eugene F. Fama. 1992. “Diversification Returns and Asset
Contribution.” Financial Analyst Journal, vol. 48, no. 3 (May/June): 26 - 32.

Bullen, P.S. 2009. “Accentuate the Negative.” Mathematica Bohemica, 134, no. 4, 427 – 446.

Chambers, R. Donald and John S. Zdanowicz, “The Limitations of Diversification Returns.”

Journal of Portfolio Management, vol. 40, no.4 (Summer): pp.65 – 76

Hallerbach, Winfried G. 2014, “Disentangling Rebalancing Return”, draft, February

Hayley, Simon, Keith Cuthbertson and Nick Motson, “Diversification Returns, Rebalancing
Returns, and Volatility Pumping.” draft, September 2013

Lo, Andrew W. and A. Craig Mackinlay, 1990. “When are Contrarian Profits Due to Stock
market Overreaction?” The Review of Financial Studies, Vol. 3, No. 2, pp. 175-205.

Mindlin, Dimitry, 2011, “On the Relationship between Arithmetic and Geometric Returns.”
CDI Advisors, LLC

Rulik, Ksenya, 2013. “Can the Rebalancing Bonus Enhance Beta Return?” Journal of Indexes,
October

Qian, Edward E. 2005. “Risk Parity Portfolios.” Research Paper, PanAgora Asset
Management.

Qian, Edward E. 2006. “On the Financial Interpretation of Risk Contribution: Risk Budgets
Do Add Up”, Journal of Investment Management, Vol. 4, No. 4, Fourth Quarter.

40
Qian, Edward E. 2012. “Diversification Return and Leveraged Portfolios.” Journal of
Portfolio Management, vol. 38, no.4 (Summer): pp.14 – 25.

Qian, Edward E. 2014a. “To Rebalance or Not to Rebalance: A Statistical Analysis of the
Terminal Wealth of Fix-weight and Buy-and-hold Portfolios.” Draft, January

Qian, Edward E. 2014b. “Mathematical Problems in Portfolio Rebalancing.” private notes.

Willenbrock, Scott. 2011. “Diversification Return, Portfolio Rebalancing, and the

Commodity Return Puzzle.” Financial Analyst Journal, vol. 67, no.4 (July/August): pp. 42 -
49.

E NDNOTE

IThe variance considered here is generalized variance with weights that are weights of the portfolio under
consideration. If the portfolio is the equal-weighted portfolio, then the variance is the conventional variance
in which each sector is given equal weight.

II If it were cumulative returns, the variance would grow as N.

This is considered as a one-sample t-stat for the return difference rather than two-samples of returns of
III

both assets.

When the means of two assets are not the same, the probability of positive rebalancing return would be
IV

smaller and can be approximated by non-central t-distribution.

VThis is apparently the reason behind the unflattering term “volatility pumping” being associated with
portfolio rebalancing.

VIThese returns can be extended farther to cover much longer periods. However, as we explained in the text,
when N becomes very large, the BH portfolios tend to be dominated by the assets with the higher returns. In
that case, the approximation of return effect becomes problematic. And the BH portfolios outperform the FW
portfolios.

VIIWhile it is hard to state the exact reason why all three approximations improve when the portfolio has
more weight is bonds than in stocks, one can speculate that portfolios with more exposures to bonds are
more balanced in terms of both return contribution and risk (volatility) contribution. Balanced contributions
lead to better approximations to the volatility and return effects.

Both matrices Σv and Σg are so-called distance matrix because their elements are related to pair-wise
VIII

distances between M points in certain vector space. For Σg , the space is a one-dimensional line segment and it
can be proven that Σg is singular with a rank of at most 3. For Σv , the space is one with random variables and
in general it is not singular.

IXThe simulation procedure is analogous to monkey throwing darts onto a board with 10 equally divided
slices. In the first step we generate 10 numbers based on a random variable with uniform distribution in the

41
interval [0,1]. In the second step, we rescale the 10 numbers as weights so that they sum to one. Even though
the mean weights tend to be equal, 10,000 portfolio exhibit considerable variation.

XLeveraged ETFs based on a single capitalization-weighted index always have negative volatility effects
because capitalization-weighted indices are BH portfolios with zero volatility effects.

XI Geometric mean – arithmetic mean inequality.

One usually have to use numerical methods to derive notional weights. But for the case of two risky assets,
XII

the weights are inversely proportional to volatilities.

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