Finding Funds with Diversification Potential

Downside versus upside betas

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


  • Downside betas do not help to identify diversifying strategies
  • These need to be combined with upside betas
  • Betas to the S&P 500 were more useful than betas to the VIX


In our article Downside Betas vs Downside Correlations (read Downside Betas vs Downside Correlations) we contrasted the downside and upside betas of eight hedge fund types that are marketed as diversifying strategies. Unfortunately for investors, none of these offered attractive diversification features. Either they provided the same upside as equities, but also the same downside, or the downside risk was as much reduced as the participation in the upside.

In this article, we will screen the downside and upside betas of a wide range of ETFs and mutual funds and seek to identify ones with attractive diversification potential.


First, we calculate the upside and downside betas of approximately 25,000 US-traded mutual funds and ETFs to the S&P 500 and VIX. For example, the downside beta to the S&P 500 is computed by only considering the days when the S&P 500 had negative returns. The lookback period is the last five years, which includes a bull market between 2018 and 2021, a crash in 2020, and a bear market in 2022.

Given that we want securities that offer diversification benefits, we initially focus on the funds with the most negative downside betas. These should increase when the S&P 500 is declining. However, selecting the top 10 funds highlights that these are all ETFs that go long the VIX or short sectors like semiconductors or market segments like the Russell 2000.

Adding such directional bets to an equities portfolio generates limited diversification benefits as they are too negatively correlated to the S&P 500, which is indicated by the strongly positive betas to the VIX. If an investor wants to reduce his equity risk, he would be better off simply selling equities and moving into cash.