A mutual fund's R-squared is a statistical comparison tool that investors use to compare a fund to its benchmark. A higher R-squared value means the fund moves with the benchmark. Watching this metric can allow you to monitor your mutual fund and make investment decisions based on how it performs.
Learn how to use a mutual fund's R-squared and whether you should add it to your toolbox.
Definition and Example of R-Squared
R-squared is one of the most basic measuring tools for mutual fund analysis. It is a metric you can use to assess the degree to which a given fund matches its benchmark.
- Alternate name: Coefficient of determination
- Acronym: R2
R-squared does not measure how well a mutual fund or your portfolio performs. Instead, it compares your portfolio's returns to a benchmark and expresses that as a percentage between 1 and 100. The higher the figure, the more your portfolio mirrors the index or benchmark. For example, an R-squared of 100% means that your mutual fund's growth (or decline) is fully in sync.
For example, the S&P 500 stock market index is mirrored by the Vanguard 500 Index Admiral (VFIAX). On May 24, 2022, the fund had an R-squared of 100.00, which meant that it was tracking the performance of the S&P 500.
Some funds do not attempt to track an index but rather invest in companies in a sector without a comparative index. For example, the Fidelity Select Telecommunication Portfolio (FSTCX) seeks capital appreciation instead of tracking an index. FSTCX could only be compared to an identical fund to get an R-squared.
How Does R-Squared Work?
As a statistical measurement, R-squared expresses the relationship between two data sets generally used in a simple linear regression model. When used to evaluate mutual funds, returns from the fund and the index it tracks are the data sets. Several steps are necessary to calculate a fund's R-squared, so it's best to view your fund's performance information where the value is generally published.
Put simply, variances—the spread between numbers in a data set—are used to determine R-squared. Brokerages generally show a fund's R-squared on its page, so you're not required to run a regression yourself to find the value.
To find a mutual fund that tracks its index, you look on the fund's page and locate the R2, which can be categorized into three tiers:
- 1–40%: low correlation to the benchmark
- 41%–70%: average correlation to the benchmark
- 71%–100%: high correlation to the benchmark
You'd choose a fund that corresponds closely to the benchmark based on your preferences. Generally speaking, you'd want to select funds with a very high R2, such as 98% or more.
What Does R-Squared Mean for Investors?
Mutual funds can be created to track the performance of many indexes. Some examples of indexes are:
- S&P 500
- Nasdaq Composite
- FTSE All-World Index
- Euro Stoxx 50 Index
- Dow Jones Industrial Average
- S&P 500 Communication Services
- Dow Jones US Utilities
There are hundreds of indexes that a fund's management can choose as benchmarks for their funds. The R-squared plays an essential part for investors, because it allows them to see how well the fund they have invested in tracks the selected index.
When you're evaluating a mutual fund, you should use R-squared along with other metrics and indicators.
If a mutual fund that is designed to track an index has an R-squared of anything less than 95%, then there is something causing it not to follow its benchmark. A good mutual fund should be managed to track its index within a few percentage points—you might hear recommendations for 90%, 80%, or even 70%—but a fund that far below the index may not be the best choice for a retail investor.
When you're choosing mutual funds, you may find more than one that you'd like to invest in. To ensure that you're diversifying your portfolio, try not to select multiple funds that invest in the same sectors and companies. It's also important to ensure that all of your funds track the index they are designed to follow.
- R-squared is a statistical metric you can use to compare a fund to its benchmark.
- R-squared values are expressed as a percentage between 1 and 100. A higher R-squared value shows how well the fund moves with the benchmark.
- You should choose funds that track within a few percentage points of their benchmarks, with an R-squared of no lower than .95, or 95%.
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.