Relation Strategies

Updated 01/17/12

This sections discusses how to use correlation in trading strategies.

Correlation is a measurement of the strength of the relationship between the fund and the index (red and green lines of the T Chart). Correlation measures the extent to which the movements of the issues are similar. FastTrack's correlation is computed according to an algorithm published in "Biometry", Robert Sokal and F. James Rohlf, W.H. Freeman, 1969, Page 509.

Click to learn how to change Correlation Settings 

High Correlation Issues

For example, view Vanguard Index Trust 500(VFINX, green) and  Vanguard Total Market Index (VTSMX, red).

If Cor= is 1.0, then the red and green lines have perfect correlation.  In this case the correlation is 98%, very high. Both these index funds from Vanguard are mostly the S&P 500 stocks.

No Point Short-term Trading

When funds are highly correlated and have about the same historical total returns, there is no point trying to devise short-term switching strategies. There is not enough differential in the short-term fund movements to make a difference.

But they can be traded long-term. Use AccuTrack® with long parameter settings (like 25 100) to trade between high Cor= growth funds. This will pick up slight differences with very few trades per year . . . Think of this strategy as a safety check. If one of the fund managers begins doing deviating, then the indicator will take you to the better issue.

Low Correlation Issues

These two sector funds are affected by different governmental regulations, population demographics, technology developments, and investor sentiments.

The correlation is a low 56%, You can expect to have trading opportunities between these sectors.

The AccuTrack® indicator shows where to trade between the funds to get the J Chart's red/green composite return of 35%/year . . . Much better than either of the two funds alone.

This same type of trading can be done between stocks. Time the sector rotation using averages of stock sectors or indices and apply the timing signals to individual issues in each sector.

Negative Correlation - the Perfect Pair

If Cor= has the value of -1.0, then the fund and index are perfectly negatively correlated. The best examples of negative correlation in the database are two Rydex funds (Rydex Nova RYNVX and Rydex Ursa RYURX). These funds are intended by the manager to run a highly negative Cor=. They are designed for professional market timers, and not the average investor.

How Could I Lose with These Funds?

Not only can you lose, you can lose big time. It is guaranteed that when one fund is up the other is down. You will be depending on pure market timing.

This is NOT a strategy where you can use FastTrack tools to pick the better fund. When we recommend switching between fund pairs, it always involves two funds with good long-term fundamentals . . . bear funds only have short-term potential to gains.

But Isn't This AccuTrack® Heaven?

NO! AccuTrack® does well picking the stronger of two independent funds, but we are only dealing with ONE set of data for these Rydex funds . . . Nova always runs with the S&P 500 and Ursa always runs against it. AccuTrack® has no advantage over moving averages in this situation.

In fact, AccuTrack® will not compute signals when two issues are two closely correlated. In such cases, AccuTrack® would do no better than a moving average.

Other Negatively Correlated Pairs

Some of the stronger negative correlations over the past 10 years include pair ZERO-COUPON bond funds with gold funds: BTTNX vs. XAU-I. Strength in gold stocks often is accompanied by weakness in the bond markets as both react to inflation speculation.

However, profits from trading to gold funds are difficult to achieve. The opposite movement between gold and bond funds often does not occur in trends that are long enough to trade using mutual funds.

The J Chart portrays a lot of switching whose net result in a sad, sub-5% annualized return. You will always find trading between sectors with good fundamentals for gains more satisfactory that trying to hedge against losses.

There are Contrary Strategies that use AccuTrack® in reverse.

Energy vs. Transportation

One of the better examples of low correlation trading includes FSESX vs. FSAIX. Not only do these funds have low correlation, but also there have been long periods where they actually have negative correlation.

Both sectors respond to energy prices. Fidelity Select Energy Services (FSESX) does well when energy prices rise. Fidelity Sel Air Transportation (FSAIX) does well when energy prices fall . . . fuel cost is a big factor in profit margin.