R-squared in mutual funds is a statistical tool that investors use to compare a fund to a given benchmark. A higher R-squared value means the fund moves with the benchmark. Watching this metric can allow investors to monitor their assets and maintain a more diversified portfolio.
Learn more about how a mutual fund's R-squared works, and whether you should add it to your toolbox as you invest in mutual funds.
- R-squared, or R2, in mutual funds, is a statistical metric you can use to compare a fund to a given benchmark.
- R-squared values are expressed as a percentage between 1 and 100. A higher R-squared value means the fund moves with the benchmark.
- Knowing a fund's R2 is a way to help maintain a more diversified portfolio, because you can check that your investments don't all align to the same benchmarks.
What Is R-Squared?
One of the most basic measuring tools for a complete analysis of mutual funds is called R-squared. This is a metric that you can use it to assess to what degree a given fund matches a given benchmark.
R-squared does not measure how well a mutual fund performs, or how well your full portfolio performs for that matter. Instead, it compares your portfolio's returns to a set benchmark and expresses that as a percentage between one and 100.
The higher the figure, the more your portfolio mirrors the benchmark. An R-squared of 100% means that the growth (or decline) of your portfolio is fully in sync with the growth (or decline) of the benchmark.
How Does R-Squared Work?
When you're thinking about whether to invest in a mutual fund, you should know not only how it performs, but also how it fits into your portfolio as a whole.
R-squared can help you choose the best funds by planning the diversification of your portfolio.
Diversification is a key factor when you invest to prevent against the risk of losing all your money at once.
For example, let's say you hold an S&P 500 mutual fund with a high R2, when you compare it to the S&P 500. You will want to find a fund with a lower correlation (lower R2) to help balance things out. Holding both types of funds would be one method to help you build a portfolio of diversified mutual funds.
How Do I Assess an R-Squared Measure?
R-squared values fall into three tiers:
- 1–40%: low correlation to the benchmark
- 40%–70%: average correlation to the benchmark
- 70%–100%: high correlation to the benchmark
If a professionally-managed fund has an R-squared value over 85%, and you wish to invest in that fund, you will have to pay fees to the firm. Or you can go avoid the fees and pay less if you simply buy into an index fund that aligns with the benchmark, and does the same thing.
R-squared can also be a handy way to assess the current funds in your portfolio to be sure their style has not "drifted" toward that of the benchmark. If any funds are too close or too far away from the benchmarks they started with, you can sell and buy into funds that maintain your original portfolio diversification.
Do I Need to Use R-Squared?
R-squared is a useful tool for diversification purposes. It can be used to check how well the funds or assets in your portfolio perform. This can help you decide whether you want to keep them or not.
On the other hand, you can also build diversification through the funds you choose to buy. The simple practice of making sure the funds in your portfolio come from many types of mutual funds can be enough to build a diversified portfolio of mutual funds. Hybrid funds can also help you diversify, while meeting (or diverging from) major benchmarks.
While R2 can provide a solid basis to compare to benchmarks, it's not the only way. You or your advisor may have many other metrics or tools to do the same, and to ensure that you maintain a diverse portfolio.