Diversification Return and Leveraged Portfolios

Portfolio rebalancing is essential for harvesting diversification return. A portfolio composed of a single security (the extreme case of non-diversification) requires no rebalancing and hence yields no diversification return. A diversified portfolio, if left alone and not rebalanced, does not provide diversification either, and worse still can become non-diversified over time as in the case of capitalization-weighted indices. In other words, diversification and rebalancing are inseparable. But what is the underlying dynamic of rebalancing that leads to a positive diversification return for a typical portfolio? This question is crucial to an understanding of the source of diversification return and in extending the analysis leveraged long-short portfolios.