Quantifying Portfolio Diversification Benefit via Return Indifference Curves

While the concepts of portfolio optimization and diversification are extremely well explored in the academic literature, relatively little has been written on how to assess the incremental benefit of adding a new asset class to an existing portfolio based on the characteristics of that asset class and its interaction with the portfolio. In this article, the authors introduce the concept of a <italic>return hurdle</italic>, corresponding to the return required from a particular candidate asset class to improve the risk–return characteristics of an existing portfolio for a given allocation size. They demonstrate how return hurdles vary as a function of correlation, creating <italic>return indifference curves</italic> that explicitly illustrate the trade-off between required asset class return and potential diversification benefit. The authors illustrate the value of the framework by comparing theoretical return indifference curves with what may be achievable in practice based on the performance of a range of different hedge fund portfolios targeting specific levels of equity correlation.