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Returns are the yardstick for mutual fund performance, but the figures don’t always tell how a fund behaves against the market it seeks to track. Two funds can have similar returns but have radically distinct trajectories. One may closely track its benchmark, while another may be more independent in stock picking or sector allocation. This association is well understood by R-squared (R²).
It explains how much of the change in a fund’s performance is due to changes in its benchmark. The higher the R-squared, the better the correlation. The lower the number, the more the fund's moves are driven by factors outside the benchmark.
This article explains what R-squared is in mutual funds and why it matters to investors.
Key Takeaways
- R-squared evaluates how a mutual fund tracks its benchmark.
- Its value is from 0% to 100%.
- The larger the value, the stronger the benchmark alignment.
- The lower the value, the more independent the fund is.
- R-squared does not indicate the quality of a fund or its future returns.
- This is especially beneficial for comparisons of active and passive funds.
- Investors should consider it along with alpha, beta, and other fund parameters.
What Is R-squared in Mutual Funds?
R-squared is a statistical indicator that represents the percentage of a fund’s performance that can be attributed to changes in a benchmark index.
It answers the question: What percentage of the fund’s moves is explained by its benchmark?
The value is between 0 and 100 percent. If the R-squared score is near to 100%, then it shows that the fund is highly correlated to the benchmark. The lower the value, the less the benchmark changes explain the fund's performance.
So if a fund has a 90% R-squared, for example, then about 90% of the variation in its returns is statistically related to movements in its benchmark over the period analysed.
It’s vital to realise that R-squared is not a rating of a mutual fund. A high value does not mean a fund is better, and a low value does not suggest it is worse.
How Does R-Squared Work?
R-squared is calculated using the correlation between a mutual fund's returns and those of its benchmark.
The basic formula is:
R² = (Correlation between fund and benchmark)² × 100
Suppose the correlation between a fund and its benchmark is 0.90.
R² = (0.90)² × 100 = 81%
This means 81% of the variation in the fund's performance is statistically explained by movements in the benchmark.
The remaining variation may come from factors such as stock selection, sector allocation, cash levels, and other portfolio decisions.
How to Interpret R-squared Values?
R-squared can broadly be understood using the following ranges:
| R-squared | Interpretation |
| 1% to 40% | Low relationship with benchmark |
| 41% to 70% | Moderate relationship |
| 71% to 100% | High relationship |
These ranges are only broad guidelines. The appropriate R-squared level depends on the fund's investment objective and strategy.
High R-squared
High R-squared signifies the fund's movements are highly correlated with its benchmark.
For example, a fund with an R-squared of 95 per cent has historically traded very closely with its benchmark. This is the sort of relationship that we can expect from index funds, which are designed to track a specific index.
Low R-Squared
The smaller the R-squared, the less the benchmark explains the fund’s movement.
This is evident in actively managed funds that intentionally deviate from their benchmark through stock selection, sector allocation, or other investing decisions.
So, low R-squared should not always be considered as bad.
R-squared Example
Suppose two equity mutual funds use the Nifty 50 as their benchmark.
| Fund | R-squared | What It Indicates |
| Fund A | 95% | Closely follows the benchmark |
| Fund B | 60% | Has a more moderate relationship |
Fund A's performance is more closely associated with Nifty 50 movements. Fund B behaves more independently and may have greater exposure to investments that differ from the benchmark.
This does not mean Fund A is automatically a better investment. Investors still need to consider returns, risk, costs, and investment strategy.
Why Is R-squared Important?
1. Helps Understand Benchmark Alignment
R-squared shows how closely a fund behaves in relation to its benchmark. This can help investors understand whether a fund is closely following the market index or taking a more differentiated approach.
2. Helps Compare Active and Passive Funds
An index fund is designed to track its benchmark, so a high R-squared is generally expected. An actively managed fund may have a lower R-squared because its portfolio can differ considerably from the index.
3. Adds Context to Other Metrics
R-squared becomes more useful when considered with measures such as beta and alpha. Together, these metrics can provide a better understanding of a fund's relationship with its benchmark.
4. Helps Understand Fund Behaviour
Investors can use R-squared to see whether a fund's movements are largely linked to its benchmark or driven by other portfolio factors.
R-squared vs Beta
R-squared and beta are often discussed together, but they measure different things.
| Feature | R-squared | Beta |
| Measures | Relationship with benchmark | Sensitivity to benchmark movements |
| Range | 0% to 100% | Can be below, equal to, or above 1 |
| Main question | How closely does the fund move with the benchmark? | How much does the fund move compared with the benchmark? |
| Higher value | Stronger benchmark relationship | Greater sensitivity to benchmark movements |
R-squared vs Adjusted R-squared
Adjusted R-squared is an upgraded version of R-squared that has been adjusted for the number of variables in the model. The R-squared generally explains the percentage of a fund’s performance fluctuation that can be explained by its benchmark.
The adjusted R-squared is more informative when more than one explanatory variable is included since it adjusts for model complexity. The R-squared is often the most intuitive metric for simple fund-to-benchmark analysis.
Is a Higher R-Squared Better?
The ideal R-squared depends on the fund's objective. For an index fund, a high R-squared may be desirable because the fund is expected to closely follow its benchmark.
On the other hand, an actively managed fund may intentionally have a lower R-squared because the fund manager is taking positions that differ from the index.
Investors should ask whether the fund's R-squared is consistent with its investment strategy, rather than simply looking for the highest number.
| Investment product | Expected R-squared | What it generally indicates |
| Index fund | 90%+ | Closely tracks its benchmark, as intended |
| Index ETF | 90%+ | Closely mirrors its benchmark, with relatively little deviation |
| Actively managed fund | Can be lower | May deviate from the benchmark as the manager selects investments to pursue additional returns |
Limitations of R-squared
R-squared is a backward-looking metric based on historical data, and it should not be used on its own to predict a fund's future performance.
It Does Not Measure Returns
A high R-squared only indicates a strong relationship with the benchmark. It does not tell you whether the fund has generated attractive returns.
It Does Not Measure Overall Risk
R-squared focuses on the fund's relationship with its benchmark. It does not capture every risk associated with the fund, such as concentration or liquidity risks.
It Is Backward-Looking
R-squared is based on historical performance data. The relationship between a fund and its benchmark can change over time.
It Depends on the Benchmark
A fund's R-squared can differ depending on the benchmark used. Investors should consider whether the selected benchmark is appropriate for the fund's investment strategy.
It Does Not Measure Fund Manager Skill
A high R-squared does not tell investors whether the fund manager has created value through stock selection or other decisions.
How Can Investors Use R-squared?
R-squared is particularly beneficial when investors want to see how much a fund acts like its benchmark.
For example, R-squared can be used to demonstrate how tightly an index fund has historically tracked its benchmark vs an actively managed equities fund.
Similarly, if two actively managed funds produce similar returns but have extremely different R-squared values, the measure might illustrate how differently they approach their benchmarks.
Still, it should be combined with other factors such as:
-
Historical returns
-
Alpha
-
Beta
-
Standard deviation
-
Sharpe ratio
-
Expense ratio
-
Investment strategy
-
Risk profile
This provides a more complete picture of the fund instead of relying on a single statistical measure.
Conclusion
R-squared measures how closely a mutual fund's performance follows its benchmark. A higher value indicates stronger alignment, while a lower value suggests greater independence. High R-squared may suit index funds, whereas active funds can show lower readings. Investors should use R-squared to assess fund behaviour, alongside returns and risk measures.
