### Asset Class Diversification Effectiveness Factors

**May 12, 2014** - Strategic Allocation

What factors make asset class diversification work? To investigate empirically, we consider the following mix of exchange-traded funds (ETF) as 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 monthly gross return-risk ratio (average monthly return divided by standard deviation of monthly returns) for an equally weighted, monthly rebalanced portfolio of all nine asset class proxies. We then recalculate the return-risk ratio nine times, each time excluding one of the assets, and relate the resulting return-risk ratios to three characteristics of the respectively excluded assets: (1) average monthly return; (2) standard deviation of monthly returns; and, (3) average (pairwise) cross-correlation of monthly returns with the other eight assets. The objective is to determine whether any of these three characteristics explain asset contribution to diversification benefit. We ignore trading frictions associated with monthly rebalancing, which would be similar for all combinations. Using dividend-adjusted monthly returns for the above nine asset class proxies during September 2006 (so that monthly returns for all assets are available in equal-weight calculations) through April 2014 (92 monthly returns), *we find that:* Keep Reading