ABSTRACT
This chapter is devoted to the analysis of volatility effect. The derivation of “diversification return,” which is simply an approximation of volatility effect, is based on the approximate relationship between arithmetic and geometric means. For portfolios with more than two assets, portfolio rebalancing obviously involves all the assets in the portfolio. In the two-asset case, the diversification return is at its maximum when the two assets are equally weighted in the portfolio. In a long-only portfolio, rebalancing is achieved by selling winners and buying losers. The diversification return of two-asset long-short portfolios is always negative. Inverse and leveraged Exchange-Traded Funds (ETFs) are different from other ETFs in terms of portfolio rebalancing. A special case of long-short portfolios is one in which the only short position is in the risk-free assets, and all others are long positions in risky assets. Since the portfolio remains long-only, the positive diversification effect among the assets remains.
