Alternate name: Coefficient of determinationAcronym: 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.
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 benchmark41%–70%: average correlation to the benchmark71%–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 500Nasdaq CompositeFTSE All-World IndexEuro Stoxx 50 IndexDow Jones Industrial AverageS&P 500 Communication ServicesDow 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. 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.
