Asset Class Diversification Effectiveness Factors

What factors make asset class diversification work? To investigate empirically, we consider the following mix of asset class proxies (the same used in “Simple Asset Class ETF Momentum Strategy”):

PowerShares DB Commodity Index Tracking (DBC)
iShares MSCI Emerging Markets Index (EEM)
iShares MSCI EAFE Index (EFA)
SPDR Gold Shares (GLD)
iShares Russell 1000 Index (IWB)
iShares Russell 2000 Index (IWM)
SPDR Dow Jones REIT (RWR)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (Cash)

We calculate the cumulative trajectory for an equally weighted, monthly rebalanced portfolio of all nine asset class proxies. Then we recalculate the trajectory nine times, each time excluding one of them, and relate the resulting terminal values to three individual asset return characteristics: (1) average monthly return; (2) standard deviation of monthly returns; and, (3) average pairwise correlation of returns with the other eight assets. We ignore trading frictions associated with monthly rebalancing, which would be similar for all combinations. Using adjusted monthly returns for the above nine asset class proxies from September 2006 (allowing comparison with the momentum strategy output for the entire set of assets) through April 2013 (80 monthly returns), we find that: (more…)