What is R-Squared in Mutual Fund

While choosing a mutual fund, just looking at the returns is not enough. It is also important to understand how well the performance of the fund matches the benchmark. R-Squared is a figure that shows this connection. It tells whether the fund is moving like the index or is generating different returns. In this blog, the meaning of R-Squared, its utility, and its role in investing have been explained in simple language.

R-Squared Meaning in Mutual Funds

R-Squared, abbreviated as R², is a statistical metric that indicates the extent to which a mutual fund’s returns are correlated with its benchmark index. It is usually measured as a score between 0 and 100.

If a fund has an R-Squared score close to 100, it means that the fund’s movements are almost exactly following its index. On the other hand, if the score is close to 0, then the fund’s performance is significantly different from the index – i.e., the fund manager is generating returns based on his own decisions.

For example, an index fund’s R² is usually between 98–100 as its sole purpose is to track the benchmark. While an actively managed fund may have a slightly lower R², as the fund manager’s strategy has a greater influence. 

R-Squared is not an indicator of returns, but it shows how well the fund and the index are aligned. It is important to understand this as it helps in understanding the nature and management style of the fund.

How R-Squared Helps Measure Fund Performance Accuracy?

When a fund moves with the market, it does not necessarily mean that it is performing well. Sometimes, all you need to know is how much the fund is working in the right direction - this is where R-Squared comes in handy.

This metric shows how closely the fund's behavior matches the index it claims to track. If a fund's R-Squared is very high, it means that its actions are very much linked to the benchmark. That is, the fund sees index-like movements, which is considered correct for most passive funds.

On the other hand, if the R-Squared is low, it means that the fund's returns are moving in a different direction from the benchmark - here, the role of the fund manager's strategy becomes important. In this way, R-Squared helps to estimate how much logic and how much risk is involved in the fund's movement. It is especially useful when the returns look good, but the reason for them needs to be understood.

How to Interpret R-Squared Values in Mutual Funds?

R-Squared is a correlation metric expressed as a percentage (0–100%) that indicates how much of a fund’s variability can be explained by its benchmark.

It is explained below:

• 0–40%: Very low correlation. Often active funds seek returns that deviate from their benchmarks by following a different strategy.

• 41–70%: Medium correlation. Indicates both the influence of the benchmark and the independent strategy of the manager.

• 71–100%: High correlation. Index funds typically range between 85–100%

For example, SBI Nifty Index Fund Direct Growth recently recorded an R?Squared of 100%, i.e., it perfectly tracks the movement of the Nifty 50. While ICICI Prudential Value Discovery Fund has an R-Squared of around 88%, which indicates that it shows higher divergence from the index

Keep in mind, this metric only indicates correlation, not quality of performance. Hence, it should be considered in conjunction with other metrics like alpha, beta, or the Sharpe ratio.

Why R-Squared Is Important in Mutual Fund Analysis

• Shows the real picture of the strategy: Not every fund is good or bad; what matters more is its performance. R-Squared makes it clear whether the fund's performance has come from its own investment policy or if it is just following the market trends. This helps the investor to know whether there is any innovation in the fund or not.

• Helps to understand the difference between active and passive funds: Sometimes the fund looks active, but in practice, it is just like the index. In such a case, R-Squared becomes a reliable way to identify whether the fund is really following the manager's research or is just copying the index.

• Helps to understand the risk profile in depth: If the fund's movement is different from the benchmark, then R-Squared will be low, and this means that the risk or uncertainty in the fund may be higher. On the other hand, a higher score indicates that the fund is inclined towards stability. This makes it easier to guess what the risk of the portfolio will look like.

• Guide to long-term investment decisions: R-Squared is not used to understand short-term trends, but to decide the long-term investment structure. It determines the type of funds that should be in the portfolio – those that match the index or those that deviate from it.

• Supports better understanding of other metrics: Figures like Alpha, Beta, or Sharpe Ratio appear more accurate when R-Squared is analysed along with them. This background helps in understanding whether the returns are due to talent alone or the movement of the market.

What Is a Good R-Squared Value in Mutual Fund Investing

• For index-based funds: If a fund follows Nifty, Sensex, or any other market index almost exactly, its R-Squared score should usually be between 95 and 100. This indicates that the fund is closely linked to the market movements. Such funds are usually passive funds, in which the fund manager has a limited role.

• For actively managed funds: For actively managed funds like value investing, multi-cap, or thematic funds, a good R-Squared range is considered to be between 70 and 90. This means that the fund is not completely tied to the market index and reflects the strategy and research of the fund manager.

• How to analyse value: If a fund has an R-Squared score of around 85, it indicates that the fund is linked to the index but is not completely dependent on it. This could mean that the fund is keeping up with market trends while also applying its own active approach.

• Assess the investor’s goals: It is not possible to call the R-Squared value “good” or “bad” without looking at the investor’s goals. For those who want stable performance like the index, a high score is better. For those who are looking for different performance or active management, a mid-range score is more suitable.

R-Squared in Equity vs Debt Mutual Funds

R-Squared is one such mutual fund analysis parameter that behaves differently in both equity and debt funds. Debt mutual funds are usually linked to benchmarks whose movements are relatively stable, like the CRISIL Composite Bond Fund Index. Hence, the R-Squared value is usually high (90-100) as the fund performance remains close to the benchmark.

On the other hand, equity mutual funds mostly have active management. Here, the stock picking and strategy of the fund manager has more influence, hence their R-Squared is usually a little lower (70-90). This means that the fund is somewhat linked to the index, but it also reflects a different mindset.

Is It Right to Rely Only on R-Squared?

• It indicates only tracking, not performance: The R-Squared ratio in mutual funds shows how closely the fund follows its benchmark, but it does not tell whether the fund has performed better or not. Therefore, it should not be considered a performance meter.

• Using it alone gives an incomplete picture: Mutual fund R-Squared score shows only correlation. It should always be combined with other fundamental metrics like Alpha, Beta, and Sharpe Ratio. Only then can the quality and skill of a fund be correctly identified.

• It does not always reflect diversification: Sometimes, there may be many different asset classes or sectors within the fund, but if they are matching the benchmark, then the R-Squared score can be high. This does not give an understanding of how much the fund has actually diversified.

Conclusion 

R-Squared in mutual funds is an indicator that shows how closely the fund's movement matches the benchmark. Understanding this makes it clear how much independent thinking the fund manager has shown in his strategy. However, it is important to know that this is just a correlation metric, not a complete assessment of performance or risk. Therefore, along with what R-Squared in mutual funds, it is equally important to look at Alpha, Beta, and other metrics. Investment decisions should not be based on a single figure, but should be made by looking at the whole picture - only then is it possible to choose the right fund.

FAQs

Q1. What is R-Squared in mutual funds?

R-Squared is a mutual fund metric that indicates how well a fund's performance matches its benchmark.

Q2. Is a higher R-Squared always better?

No, it depends on the strategy of the fund. Active funds do not require a very high score.

Q3. Can I use R-Squared alone to select a mutual fund?

No, it should be considered in conjunction with other metrics such as Alpha, Beta and Sharpe Ratio.

Q4. What is a good R-Squared value for equity funds?

A score between 70 and 90 is considered good for equity funds, especially if the fund is actively managed.

Q5. Is R-Squared useful for debt funds?

Yes, debt funds mostly have a score above 90 as they closely follow the benchmark.