Diversification versus Hedging II

Which one should investors pursue?

June 2023. Reading Time: 10 Minutes. Author: Nicolas Rabener.


  • Ideally diversifying funds are uncorrelated and generate positive returns
  • However, identifying such funds is more challenging than expected
  • Creating a diversified portfolio requires thoughtful fund and asset class selection


In our last research note (read Diversification versus Hedging), we explored creating a diversification strategy by selecting funds that exhibit negative downside betas to the S&P 500. We learned that downside betas are useful metrics for evaluating funds, but need to be viewed carefully. If too negative, then these funds essentially represent tail risk hedges, which are less attractive as investors can simply reduce their equity exposure to achieve the same effect.

In contrast, funds with only moderately negative downside betas are more useful for portfolio construction as they make money when stocks lose, but can also produce positive returns when stocks rise, at least theoretically. Bonds exhibited these unique characteristics for the better part of the last four decades until central banks started rising interest rates to combat inflation in 2022, which resulted in poor performance of the traditional 60-40 equity-bond portfolio.

In this research note, we will continue to explore creating a diversification strategy by selecting funds primarily based on their downside betas.


We rank all funds trading in the U.S. stock market, which includes mutual funds and ETFs, by their downside betas to the S&P 500, but exclude any with betas below -0.5 in order to avoid including tail risk products (try Finominal’s Diversification Booster).

We create four portfolios by selecting the top 10 funds with the lowest downside betas where we vary the lookback for calculating the downside betas between one and five years, and versions where we exclude bond funds. The reason for excluding bond funds is that most investors already have exposure to fixed income, ie these should not be considered diversifying products, and the low-interest rate environment has made t