Some mutual funds just aren't good together.
Take Trimark Canadian and Templeton Growth, for example. These respected funds have exemplary long-term performance numbers, but they're not an ideal pairing because their ups and downs match fairly closely.
A better match is AGF Canadian Growth Equity and the Trimark Fund. Their returns don't closely track each other, which means that a decline in one doesn't strongly suggest the other is struggling as well.
Let's assume you have diversified your portfolio of mutual funds to include stocks, bonds and cash, and that your equity funds cover Canada, the United States and the rest of the world. A way to further enhance your diversification would be to pick funds that don't have a history of moving up and down at the same time.
Similarity of return patterns are measured through what's known as a correlation coefficient. More and more, fund companies and financial advisers are using this technique in combination with other selection criteria to fine-tune portfolios for investors.
One way to use correlation numbers would be to make sure you haven't selected a global equity fund that happens to track your Canadian equity fund closely. That's the case with Trimark Canadian and Templeton Growth.
Another use is to guard against owning two funds in the same asset class that tend to bob up and down in unison. Templeton Growth and the Trimark Fund do this, so they're not ideal partners.
The correlation scale runs from minus-1, where two funds would move in opposite directions to each other, to 1, where the funds move in the exact same direction.
A negative correlation is ideal from a diversification point of view. Steven Kangas, a fund analyst and editor of the FundLibrary.com Web site, says a score of 0.5 or less suggests a pair of funds that fit together well. A pair of funds with a correlation score of 0.80 or more means there's probably little or no diversification benefit in holding them together.
AGF Canadian Growth Equity's five-year correlation number when paired with the Trimark Fund is 0.34, which in simple terms means the two funds move in the same direction just 34 per cent of the time. This makes them quite a good match from a correlation point of view.
A less promising pairing is Trimark Canadian and Templeton Growth, with a correlation of 0.77.
As for the Trimark Fund and Templeton Growth, their correlation rating is prohibitively high at 0.86. If you owned either of these funds, there are better choices for broadening out your global equity exposure. One possibility: BPI Global Equity, with a correlation to the Trimark fund of 0.50.
These correlation numbers were supplied by AIM Funds, which looks at how its own funds match up with each other, and how they stack up against the funds of some of its major competitors. A few other companies are also producing correlation numbers, although for their in-house funds only.
If you work with a financial adviser, ask if the funds he or she recommends for you have been put through a correlation analysis.
Do-it-yourselfers who want to look at correlation should try the Fundscope Web site at http://www.fundscope.com. Fundscope is a pay site, but it offers a free portfolio diagnostic tool that looks at fund correlation (it's called similarity here), among other things.
Another way to use correlation numbers is to help you find an ideal sector fund to complement your core funds. If you owned the Trimark Fund, then Fidelity Small Cap America would be a good possibility because the two have a correlation of 0.28.
If you held Trimark Canadian, there would probably be better choices than AGF Canadian Resources and Mackenzie Ivy Enterprise, which have correlation ratings of 0.71 and 0.72, respectively. It's also possible to create some general rules for mixing funds by using correlation numbers for stock and bond indexes, including small sector indexes.
Suzane Abboud, president of Fundscope, said her analysis shows that a bond fund makes a good offset to an index fund that tracks the Dow Jones industrial average or the S&P 500. She also found that a Canadian financial services fund mixes well with energy or gold funds. This is because these sectors have different sensitivity to inflation and interest rate movements.
As useful as correlation analysis can be, you have to know its limitations. While two funds may move in the same direction quite often and thus have a high correlation score, their actual returns may differ.
"Correlation only gives you part of the story because it doesn't show the magnitude of returns," said Gary Grad, vice-president of investment management services at Fidelity Investments Canada. "One fund could be up 1 per cent, another up 21 per cent."
The solution here in comparing funds is to check their correlation, and then look at their actual returns. The more similar, the less these funds are meant to be together.
© 2007 The Globe and Mail. All rights reserved.
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