Fund Selection: Equity Substitutes vs Diversifiers

What funds are worth buying?

October 2026. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Fund selection can be simplified into equity substitutes & diversifiers
  • Less than 5% of all funds are attractive equity substitutes
  • Less than 1% of all funds are superior diversifiers

INTRODUCTION

In 2023, J.P. Morgan’s long-term strategist Jan Loeys argued that most investors only need two funds: one for global equities and one for local bonds. Although this is sound advice, asset managers and banks make compelling cases for a wide range of other strategies, including high yield bonds, CLOs, preferreds, Taiwanese stocks, REITs, merger arbitrage, long-short equity, private equity, and cryptocurrencies.

Given the large universe of investment strategies and the many ways of combining them into portfolios, investors are often overwhelmed by asset allocation. However, investors can reduce this complexity by dividing strategies into two categories: equity substitutes and diversifiers. Equity substitutes are strategies that are moderately to highly correlated with the stock market. If they offer higher Sharpe ratios than the market (e.g., the S&P 500 in the U.S.), they can be considered attractive equity substitutes. If their risk-adjusted returns are lower, investors are better off buying the market via a passive index tracker. In contrast, low-correlation strategies are diversifiers, which we can further distinguish into superior and base diversifiers.

In this research article, we rank all U.S. mutual funds and ETFs using this simple asset allocation framework.

DIVERSIFICATION MATRIX

The starting point for almost every investor is the stock market, as it represents the core risk of most portfolios. We use the S&P 500 as the reference point and measure each fund’s Sharpe ratio and correlation with the S&P 500. A correlation of 0.5 serves as the threshold separating equity substitutes from diversifiers.

As a case study, we select eight funds representing major asset classes and map them onto this framework. Three are highly correlated with the stock market: U.S. high yield bonds (HYG), U.S. REITs (USRT), and a GMO equity mutual fund (GQLIX). However, only GQLIX generated a higher Sharpe ratio than the S&P 500 over the last seven years. From this perspective, it is questionable