What Is R-Squared?

R-Squared Definition, Benefits, and Uses With Investing in Mutual Funds

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••• Learn how to use a mutual fund R-squared or R2. Getty Images

If you want to do a complete analysis of mutual funds, you'll want to include R-squared.

But 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 masters degree in math or you're a statistics fan, it's likely you wouldn't have any knowledge of R-squared prior to your mutual fund research. Although R2 may appear complex at first, it's a simple tool to use, once you learn how to use it.

Here's what to know about a mutual fund's R2:

R-Squared Definition

R-squared (R2) 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 online research tools for mutual funds:

R-squared reflects the percentage of a fund’s movements that can be explained by movements in its benchmark index. An R-squared of 100 indicates that all movements of a fund can be explained by movements in the index.

In different 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 similar the fund performs to the index. If, for example, the fund's R-squared is 97, it means that 97% of the fund's movements (ups and downs in performance) are explained by movements in the index.

Benefits of R-squared for the Investor

R-squared can help investors in choosing 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 R-squared to the S&P 500, will want to find a fund with a lower correlation (lower R-squared) to be sure they are building a portfolio of diversified mutual funds.

R-squared can also be useful in 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.

Should You Use R-Squared?

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 sufficient to build a great portfolio of mutual funds. Additionally, and depending upon the type of fund, sufficient diversification may be achieved with at least 3 funds but no more than 8 funds.

Disclaimer:The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.