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MARCH 1994

Asset Allocation and Diversification Returns

DAVID G. BOOTH

DIVERSIFICATION IS CLOSE TO AN INVESTMENT “FREE LUNCH.” Booth and Fama1 report that
diversification can add about 50 basis points a year to the compound returns of
“60/40” (60% stock, 40% fixed income) portfolios. To capture the increased returns,
it is necessary to hold assets in constant proportions or weights. Strategies that shift
asset weights in a portfolio, such as market timing and tactical asset allocation, can
lose the incremental returns.

With constant asset weights, diversification always adds to a portfolio’s compound


return. The compound returns of the assets in such a portfolio, weighted by the amount
held in each, will add up to less than the portfolio compound return. Booth and Fama
define the “portfolio diversification return” as the difference between the portfolio
compound return and the weighted average asset compound return.

Diversification increases compound returns by dampening return volatility. The


relation between compound returns and volatility can be seen in the following example:

Year Year Two-Year


1 2 Total Average
Return Return Return Return

Portfolio 1 0% 0% 0% 0%
Portfolio 2 -50% 50% -25% 0%

The two portfolios have the same average return. Portfolio 2 has a lower compound
return because of its return variability. The value of a $1 initial investment in Portfolio
2 drops to $.50 at the end of the first year and climbs to $.75 at the end of the second year.

If diversification adds 50 basis points a year to a portfolio’s compound return, each


asset in the portfolio should get credit for its contribution to the 50 basis points. Not all
assets contribute equally to the portfolio diversification return. Those assets whose
return variances are reduced most by diversification get assigned the highest “asset
diversification return.”

1
David G. Booth and Eugene F. Fama, “Diversification Returns and Asset Contributions,” Financial
Analysts Journal, May/June 1992: 26-32.
2 Dimensional Fund Advisors Inc.

Table 1 displays the diversification returns for a hypothetical 60/40 portfolio and for
each asset in the portfolio, based on the Booth & Fama formulas (a description of the
data can be found in the Appendix). The portfolio diversification return is the weighted
average of the assets’ diversification returns.

As can be seen in Table 1, the return-enhancing benefit of diversification is much


larger for stocks than for fixed income investments. Diversification and fixed income
reduce return volatility in different ways. Fixed income lowers average returns and,
consequently, compound returns. Diversification increases compound returns.

Table 1

Asset Classes and Portfolios:


Contributions to Risk and Return
Ten Years: 1984-1993

Risk Contribution to
Compound Diversification a Balanced Portfolio
Return Return (Beta vs.
(% Ann.) (% Ann.) Portfolio Returns)
60% Global Stocks 18.53 0.86 1.61
U.S. Stocks
10% Large (S&P 500) 14.94 0.57 1.54
10% Large Value 17.00 0.41 1.39
5% Small (6-10) 11.63 1.07 1.69
5% Small Value 15.72 0.63 1.47
5% Real Estate 7.70 0.88 1.51
International Stocks
15% Value 24.63 1.14 1.80
10% Small 21.72 1.18 1.55
40% Fixed Income (Short & Intermed) 9.51 0.00 0.09
Global Portfolio 15.11 0.50 1.00
Weighted Avg. Asset Values 14.61 0.50 1.00

Measuring Diversification Returns

Booth and Fama show that compound returns can be estimated from an asset’s average
return and its variance. The relation is approximately
σ 2P
[1] CP = E(RP) -
2
where
CP = the compound return of portfolio P
E(RP) = the average, or expected, return of portfolio P
σ 2P = the variance of portfolio P

The compound return is approximately equal to the average return minus one-half of
the return variance.
Asset Allocation and Diversification Returns 3

Equation [1] shows why the variance-reducing benefit of diversification translates into
increased compound returns. The portfolio compound return will be improved by about
half of the variance reduction.

The portfolio variance is the weighted average of the N2 individual covariances between
the N assets,
N N

[2] σ 2P = ∑ ∑ xJxKcov(RJ,RK)
J=1 K=1

N N

[3] = ∑
J=1
xJ ∑ xKcov(RJ,RK)
K=1

[4] = ∑
J=1
xJcov(RJ,RP)

where xJ = the weight of asset J in portfolio P

Equation [4] says that the portfolio variance is the weighted average of the N return
covariances between each asset and the portfolio. The return covariance between each
asset and the portfolio can be restated as

[5] ßJσ 2P,

where ßJ is the beta of the asset calculated by regressing asset returns against portfolio
returns. An asset beta measures the relative contribution of each asset to the portfolio
variance. Table 1 displays the betas for the asset classes in the 60/40 portfolio. Since
fixed income betas are close to zero, and stocks are 60% of the portfolio, stock betas tend
to be close to 1.6.

The amount of each asset’s variance, σ 2J, that gets diversified away by portfolio
construction is

[6] σ 2J - cov(RJ,RP)

The diversification benefit for each asset, expressed in returns, is about half of this
variance reduction. For many fixed income strategies, equation [6] will be negative.
While interesting as a statistical quirk, Table 1 shows that the economic consequences
of the negative diversification returns are negligible.

The results in Table 1 use the following formula developed by Booth and Fama to
measure DJ, the asset return contributions:

[7] DJ = E(RJ)ln[1+E(RP)] ß Jσ 2 P
E(RP) 2[1+E(RP)]2
4 Dimensional Fund Advisors Inc.

The diversification return is the difference between the return contribution and the
compound return.

The formula produces return contributions expressed in continuously compounded


form. These are converted to annualized discrete returns in three steps. First, the annual-
ized portfolio diversification return is calculated (the difference between the annualized
portfolio compound return and the weighted average asset compound return). Second,
each asset’s monthly return contribution is calculated using equation [7]. Third, the
monthly returns are scaled by the annualized result so that the weighted average
diversification return equals the portfolio diversification return. The annualized returns
are about the same if we just multiply the monthly diversification returns by 12, since
the benefit of diversification increases with time.

Changing the Equity Commitment

Table 2 displays diversification returns for portfolios with differing commitments to the
S&P 500 and to fixed income. The table shows an increase in diversification returns for
stocks as the fixed income commitment increases. The first dollar invested in stocks has
more diversification benefit than the last dollar invested.

Table 2

S&P 500 Diversification Benefits


as a Function of S&P 500 Weights
1984-1993

Diversification Returns
Portfolio Mix (Annualized bp): S&P 500
Variance
S&P 500 Fixed S&P 500 minus
Index Income S&P 500 Covariance Covariance
(%) (%) Portfolio Index (Annualized %) (Annualized %)
5 95 5 114 0.21 2.21
10 90 10 108 0.32 2.10
20 80 19 97 0.56 1.86
30 70 25 86 0.79 1.63
40 60 29 74 1.02 1.40
50 50 30 62 1.26 1.16
60 40 29 50 1.49 0.93
70 30 26 38 1.72 0.70
80 20 20 26 1.96 0.46
90 10 11 13 2.19 0.33
95 5 6 6 2.31 0.11
100 0 0 0 2.42 0.00

Fixed Income Portfolio:


50% Dimensional’s One-Year Fixed Income Portfolio
25% Dimensional’s Five-Year Government Portfolio
25% Dimensional’s Global Bond Portfolio
Asset Allocation and Diversification Returns 5

Equation [7] shows why diversification benefits per dollar increase as the amount
invested in stocks decreases. Let k represent the proportion invested in stocks. As k
decreases, stock betas increase on the order of k. Portfolio variance is reduced on the
order of k2. Thus, the diversification benefit in equation [6] increases by an amount on
the order of k2/k = k.

Tables 3 and 4 show that asset class betas are also dependent on the asset mix.
Diversification is so powerful that the first dollars invested internationally do not
increase portfolio risk, even though international stocks are more volatile than the
S&P 500. With large international commitments, international stock relative risk is
more in line with its standard deviation.

Table 3

Diversification Benefits
Related to Asset Mix
(Annualized %)
1984-1993

Wgt. Div. Wgt. Div. Wgt. Div.


(%) Ret. Beta. Cov. (%) Ret. Beta Cov. (%) Ret. Beta Cov.

20% Stocks

U.S. Large Co. (S&P 500) 20 .97 3.37 .56 15 1.00 3.43 .56 8 .97 3.18 .47
U.S. Small Co. 6-10 5 1.55 3.44 .56 4 1.50 3.05 .45
International Large (EAFE) 4 1.66 3.57 .53
International Small 4 1.70 3.36 .50
Fixed Income 80 -.01 0.41 .07 80 -.01 .39 .06 80 -.01 0.43 .06

Portfolio 100 .19 1.00 .17 100 .22 1.00 .16 100 .27 1.00 .15

40% Stocks

U.S. Large Co. (S&P 500) 40 .74 2.26 1.02 30 .76 2.25 1.03 10 .80 2.14 .85
U.S. Small Co. 6-10 10 1.28 2.40 1.10 10 1.31 2.22 .88
International Large (EAFE) 10 1.47 2.42 .96
International Small 10 1.52 2.32 .92
Fixed Income 60 -.02 .16 .07 60 -.01 .14 .07 60 -.01 1.7 .07

Portfolio 100 .29 1.00 .45 100 .35 1.00 .46 100 .46 1.00 .40

Div Ret: Diversification return


Beta: Asset regression on portfolio
Cov: Covariance between asset and portfolio returns
6 Dimensional Fund Advisors Inc.

Table 4

Diversification Benefits
Related to Asset Mix
(Annualized %)
1984-1993

Wgt. Div. Wgt. Div. Wgt. Div.


(%) Ret. Beta Cov. (%) Ret. Beta Cov. (%) Ret. Beta Cov.

60% Stocks

U.S. Large Co. (S&P 500) 60 .50 1.61 1.49 50 .51 1.60 1.50 25 .61 1.42 1.35
U.S. Small Co. 6-10 10 1.01 1.70 1.59 10 1.14 1.53 1.45
International Large (EAFE) 15 1.33 1.58 1.50
International Small 10 1.40 1.49 1.41
Fixed Income 40 -.02 .09 .08 40 40 -.03 .08 .07

Portfolio 100 .29 1.00 .93 100 .35 1.00 .94 100 .65 1.00 .95

80% Stocks

U.S. Large Co. (S&P 500) 80 .26 1.24 1.96 60 .25 1.21 1.97 35 .42 1.19 1.63
U.S. Small Co. 6-10 20 .68 1.33 2.18 15 .91 1.28 1.76
International Large (EAFE) 15 1.10 1.30 1.78
International Small 15 1.15 1.25 1.72
Fixed Income 20 -.03 .05 .08 20 -.02 .04 .07 20 -.03 .05 .07

Portfolio 100 .20 1.00 1.58 100 .28 1.00 1.63 100 .62 1.00 1.37

Div Ret: Diversification return


Beta: Asset regression on portfolio
Cov: Covariance between asset and portfolio returns

Return Synergies

The tables show that diversification creates return “synergies.” For example, the
S&P 500 return contribution increases as small stocks and international stocks are added
to a portfolio.

Forming Portfolio Diversification Returns

The results suggest that the model equity portfolio should depend on the overall
equity commitment. A 20/80 portfolio might have relatively more in international
and small cap stocks than an 80/20 portfolio. The greater the equity commitment,
the greater the appeal of market portfolios such as the S&P 500 and EAFE indices.
Table 5 displays 4 model portfolios that allow the equity mix to change as the equity
commitment changes.
Asset Allocation and Diversification Returns 7

Table 5

Balanced Portfolios
All Available Data:
1973-1993 Conservative Moderate Normal Aggressive

Equity 20 40 60 80
U.S. Stocks 10 20 35 50
Large Cap
“Market” (S&P 500) 2 4 10 15
“Value” (High BtM) 2 4 10 15
Small Cap
“Market” (U.S. 6-10) 2 4 5 8
“Value” (High BtM) 2 4 5 7
Real Estate Stocks 2 4 5 5
International Stocks 10 20 25 30
“Value” (High BtM) 4 8 10 8
Large Cap 0 0 0 8
Small Cap 3 6 10 8
Emerging Markets 3 6 5 6
Fixed Income 80 60 40 20
U.S. Fixed Income
Five-Year Government 20 15 10 5
One-Year Fixed Income 40 30 20 10
Global Fixed Income 20 15 10 5

Compound Return (%) 11.9 13.7 14.7 15.4


Standard Deviation (%) 4.8 8.0 11.1 14.4
Lowest Annual Return (%) 0.0 (10/73-9/74) -9.8 (10/73-9/74) -18.5 (10/73-9/74) -27.0 (10/73-9/74)

Lowest Annualized
Three-Year Return (%) 6.5 (1/73-12/75) 4.3 (1/73-12/75) 2.3 (1/73-12/75) 0.0 (1/73-12/75)

Growth of $1 $10.6 $14.8 $17.7 $20.1

Real Estate Securities weighting allocated evenly between U.S. 6-10 Small and Small Cap “Value” prior to data inception January 1975. Emerging
Markets weighting allocated evenly between International Value and International Small prior to data inception January 1988. Global Fixed Income
weighting allocated evenly between One-Year Fixed Income and Five-Year Fixed Income prior to data inception January 1987. International Value weighting
allocated evenly between International Small and International Large prior to data inception January 1975. Annualized from quarterly data. All Portfolios
rebalanced quarterly. Lowest three-year returns calculated from periods overlapping quarterly.

Conclusion

An asset’s diversification and relative risk characteristics are a function of its return
variance and its covariance with other portfolio assets. The relation changes with the
amount invested in the asset.

The asset allocation decision should be based on an asset’s diversification return in


addition to its compound return. Some of the high-variance asset classes, such as
international and small stocks, have much more of their return variances diversified
away than does the S&P 500 index. A consideration of their diversifying powers may
suggest greater weightings in a portfolio.