Mutual Fund R-Squared Definition

How R2 Helps With Investing Choices

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When you're considering a mutual fund for investing, it's important to have a comprehensive picture of its performance. There are many ways to carefully evaluate this, but one of the most basic measuring tools for a complete analysis of mutual funds is called R-squared.

Before you analyze R-squared, or R2, of a mutual fund, it's important to know its definition and how to use it in mutual fund analysis.

Unless you have a master's degree in math or you're a statistics fan, you probably wouldn't have any knowledge of R-squared prior to your mutual fund research. But, although R2 may appear complex at first, it's a simple tool to use, once you learn how to use it. Here's what you need to know about a mutual fund's R2.

R-Squared Definition

R-squared is a statistical measure used for investment analysis and research that investors can use to determine a particular investment's correlation with (similarity to) a given benchmark.

Here's the definition of R2, according to Morningstar, one of the top research tools for mutual funds:

"R-squared measures the relationship between a portfolio and its benchmark index. It is expressed as a percentage from 1 to 100. R-squared is not a measure of the performance of a portfolio. Rather, it measures the correlation of the portfolio's returns to the benchmark's returns...An R-squared of 100 indicates that all movements of a portfolio can be explained by movements in the benchmark."

In other words, the benchmark is an index, such as the S&P 500, that is given a value of 100. A particular fund's R-squared can be considered a comparison that reveals how similarly the fund performs to the index. If, for example, the fund's R-squared is 97, it means that movements in the index explain 97% of the fund's movements (ups and downs in performance).

The higher a fund's R2 compared to the benchmark fund, the more similarly it will behave to the benchmark.

The Benefits for the Investor

R-squared can help investors choose the best funds by planning the diversification of their portfolio of funds. For example, an investor who already holds an S&P 500 Index fund or another fund with a high R2 compared to the S&P 500, will want to find a fund with a lower correlation (lower R2) to be sure they are building a portfolio of diversified mutual funds.

R-squared can also be useful for reviewing existing funds in a portfolio to be sure their style has not "drifted" toward that of the benchmark. For example, a mid-cap stock fund can grow in size, and the fund manager may increasingly buy large-cap stocks over time. Eventually, what was originally a mid-cap stock fund when you bought it is now a fund that resembles your S&P 500 Index fund. You can use R2 to check your fund's performance compared to others over time.

Is R-Squared Essential?

Now for the question you want answered: Should I use R-squared to choose mutual funds? Perhaps the best answer to this question, although a vague one, is "not necessarily."

R-squared is a useful tool for diversification purposes but the simple practice of making sure the funds in your portfolio represent different types of mutual fund categories will most often be enough to build a great portfolio of mutual funds. Sufficient diversification may be achieved with at least three funds but no more than eight funds, depending on the specific funds you are using. R2 can provide a useful basis for comparison, but it's not an essential metric if you or your advisor know how to ensure your portfolio is diverse enough otherwise.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

Article Sources

  1. Morningstar. "R-squared." Accessed April 28, 2020.