Time-Variation in Diversification Benefits of

Diversification benefits of three “hot ” asset classes, Commodity, Real Estate Investment Trusts (REITs), and Treasury Inflation-Protected Securities (TIPS), are well studied on an individual basis and in a static setting. In this paper, we document that the three asset classes are in general not substitutes for each other and that all ought to be included in investors ’ portfolios, based on a sample of daily return data from January 1999 through December 2005. We also find that diversification benefits of the three hot assets change substantially over time. For instance, benefits of TIPS were significant before 2001 but have been decreasing gradually since then. On the other hand, diversification benefits from Commodity and REITs fluctuate significantly over the entire sample period. We show that this observed time-variation in diversification benefit can be captured by incorporating time-varying return correlations. To see the implications of this finding for asset allocation in practice, we examine the out-of-sample performance of portfolio strategies constructed based on a variety of correlation structures. We find that Engle’s (2002) Dynamic Conditional Correlation model outperforms other correlation structures such as rolling, historical, and constant correlations. Our findings suggest that diversification benefits of the three hot asset classes do vary substantially over time and that investors need to use appropriate correlation estimates in their asset allocation decisions to adjust for such time variation