  Diversification return is an incremental return earned by a rebalanced
portfolio of assets. The diversification return of a rebalanced portfolio is
often incorrectly ascribed to a reduction in variance. We argue that the
underlying source of the diversification return is the rebalancing, which
forces the investor to sell assets that have appreciated in relative value and
buy assets that have declined in relative value, as measured by their weights
in the portfolio. In contrast, the incremental return of a buy-and-hold
portfolio is driven by the fact that the assets that perform the best become a
greater fraction of the portfolio. We use these results to resolve two puzzles
associated with the Gorton and Rouwenhorst index of commodity futures, and
thereby obtain a clear understanding of the source of the return of that index.
Diversification return can be a significant source of return for any rebalanced
portfolio of volatile assets.
