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Correlation Tool

Correlation is a statistical measure of the degree to which the returns of two funds tend to move in the same direction. The correlation coefficient ranges from 1.00 (perfect correlation) to -1.00 (perfect inverse correlation). In the table below, correlations are multiplied by 100 for ease of presentation, so perfect correlation is expressed as 100. Perfect correlation between fund x and fund y means that every time fund x moves up, fund y would move up as well. And with perfect inverse correlation, every time fund x moves up, fund y would move down. (Note correlation does not measure the magnitude of the moves only the direction.) The importance of correlation is in how it relates to portfolio construction and risk reduction. For example, two funds that carry the same risk (same relative volatility of returns), but that are not highly correlated, will, in combination, have a lower relative volatility because sometimes when one is up the other will be down and vice versa. This will smooth out the daily fluctuations in their combined return. Most funds from the same category tend to be highly correlated, but funds from different categories tend to be lower. The classic example is stock funds versus bond funds. Bond funds (excluding High-Yield) typically have very low correlations to stocks and many have negative correlations (meaning they tend to move in the opposite direction). Thus a mix of stocks and bonds will be less risky than a stock portfolio alone.