Asset Classes and Portfolio Diversification: Evidence from a Stochastic Spanning Approach

Abstract

We propose a stochastic spanning approach to assess whether a traditional portfolio of stocks and bonds spans augmented portfolios including commodities, foreign exchange, and real estate. We empirically show that in all seven portfolio combinations, the augmented portfolio is not spanned by the traditional one. Our results are further confirmed by both parametric and non-parametric tests in an out-of-sample setting. Therefore, traditional investors can generally benefit in terms of higher Sharpe ratios from augmenting their portfolio with alternative asset classes. Additional analysis demonstrates that diversification benefits can be explained by the current state of the U.S. economy and stock markets.