Downside Betas vs Downside Correlations

Quantifying the diversification benefits of alternative strategies

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

SUMMARY

  • Investors typically use correlation to identify diversifying strategies, but the metric can be misleading
  • Upside and downside betas and correlations provide a better perspective
  • Common hedge fund strategies failed to provide attractive diversification benefits

INTRODUCTION

Are investors as rational as portrayed in the finance literature?

For example, when Lehman Brothers collapsed in October 2008, investors dumped almost all assets, regardless of their nature. The mantra was to shoot first, and ask questions later. Was that rational behavior?

Tough to say, but it did highlight that there were few pockets of safety when markets go haywire. Correlations spiked and many diversifying strategies didn’t provide diversification benefits, eg mergers failed to complete and hedge funds lost money with merger arbitrage.

Typically investors use correlations for selecting diversifying strategies, but this does not necessarily lead to diversified portfolios as we have recently shown (read Myth Busting: Alts’ Uncorrelated Returns Diversify Portfolios). In this article, we will evaluate the same hedge fund strategies using downside betas and downside correlations as metrics.

DOWNSIDE BETA VS DOWNSIDE CORRELATIONS

There are multiple methodologies for computing downside betas and downside correlations. We take a simple approach and differentiate the daily returns of the S&P 500 by their sign. The goal is to identify investment strategies that are not sensitive to stock market declines.

We use a US investment-grade (IG) bond index as an example and calculate betas and correlations to the S&P 500 for the period from 2004 to 2022. We observe that the beta and correlation were approximately zero, which provides a first indication that bonds might have been a good instrument for diversifying an equities portfolio.

The downside beta and downside correlation of US IG bonds to the S&P 500 were negative, which means that bonds increased in value when stocks declined. Stated dif