R squared in mutual funds serves as a statistical tool. Determining how similar a mutual fund’s performance is to a certain benchmark index is helpful. R Squared does not indicate whether or not a given mutual fund is a wise investment choice. It merely contrasts the performance with the results of a specified benchmark.
How to Interpret a Fund’s R Squared?
Understanding a fund’s R Squared value is essential for investors. A higher R Squared indicates a stronger correlation between the fund’s performance and the benchmark. This means that a significant portion of the fund’s portfolio aligns with the benchmark. On the other hand, a lower R squared denotes a more distinctive investing approach and is less correlated with the benchmark.
Although an elevated R squared value might be appropriate for index funds that seek to duplicate benchmarks precisely, it might not be optimal for actively managed funds that strive to surpass benchmarks. As some actively managed funds deliberately depart from benchmark allocations to maximise returns, their R squared values may be lower.
To make well-informed investing selections, investors should consider a fund’s investment objectives and approach in addition to its R squared value.
How Does it Work?
The value of R Squared spans from 0 to 100. It shows the extent to which changes in a fund’s benchmark index may account for variations in its performance.
When a fund’s R Squared is 100, it indicates that changes in the index fully account for its activities. As a result, index funds that own Nifty 50 equities will have an extremely high R Squared—possibly even around 100.
On the other hand, a low R squared score for a mutual fund suggests that changes in its benchmark index do not adequately explain changes in the fund. For instance, an R Squared of 18 indicates that changes in its benchmark index can explain just 18% of the fund’s movements.
How do you Calculate R Squared?
R Squared is presented as a percentage between 0 and 100.
Three levels are assigned to an R Squared value:
- 1 to 40%: low correlation to the benchmark.
- 41 to 70%: average correlation to the benchmark.
- 71 to 100%: high correlation to the benchmark.
R Squared Calculation Formula:
Being a technical tool, R squared calculation necessitates the consideration of several statistical parameters, including correlation and standard deviation.
R Squared= Square of correlation
Correlation = Covariance between Benchmark(Index) and Portfolio/ (SD of Portfolio*SD of the benchmark)
Standard deviation is referred to as SD.
How are R Squared and Beta Related?
Beta and R squared are both tools used in mutual fund analysis, but they measure different aspects. Beta gauges a fund’s volatility compared to a benchmark, with 1 indicating similar volatility to the benchmark. Values above 1 mean higher volatility, while below 1 means less.
On the other hand, R Squared shows how much a fund’s movements are explained by changes in the benchmark. A high R Squared indicates close alignment with the benchmark, while a low value suggests less correlation.
High beta with low R Squared might mean the fund’s volatility isn’t tied to the benchmark. Together, they paint a clearer picture of a fund’s performance for investors.
R Squared and Adjusted R Squared
Statistical measurements called R Squared (R²) and Adjusted R Squared (Adjusted R²) are employed to examine the correlation between the performance of a fund and a benchmark.
R squared calculates the percentage of a fund’s changes that may be linked to changes in the benchmark. R Squared, however, occasionally exaggerates the strength of this association, particularly when other factors are ignored.
By including more independent variables in the statistical model, adjusted R squared provides a precise understanding of the correlation mentioned above. External variables improve the R squared model’s reliability. With adjusted R squared, the connection with the index that has been established by R Squared becomes a bit more dependable.
R Squared Vs Adjusted R Squared
R-Squared and Adjusted R-Squared differ in how they handle the number of predictors in a model:
- Sensitivity: R-Squared increases with more variables, regardless of their significance, whereas Adjusted R-Squared only rises when a significant variable is added and may decrease with a non-significant predictor.
- Best Use: R-Squared suits simple linear regression with few predictors, while Adjusted R-Squared is ideal for multiple regression models with several independent variables.
- Interpretation: A high R-Squared value suggests a strong relationship but can mislead with numerous variables, whereas Adjusted R-Squared provides a more reliable indication of the model’s explanatory power, especially with multiple variables.
- Reliability: R-Squared is less reliable with multiple predictors as it doesn’t penalise for adding irrelevant variables, whereas Adjusted R-Squared is more reliable in such scenarios as it penalises model complexity.
Limitations of R Squared
R-Squared has several limitations that investors should be aware of:
- Performance Evaluation: R-Squared doesn’t evaluate the quality or risk of a mutual fund. Even with a high R-Squared indicating index-like behaviour, it doesn’t assure good performance or low risk. Additionally, it doesn’t showcase a fund manager’s skill or the effectiveness of their strategy.
- Not a Performance Indicator: R-Squared focuses on correlation rather than quality. It shows how closely a fund tracks the market but doesn’t assess its actual performance. A fund may closely mirror an index yet deliver poor returns, making R-Squared an incomplete measure of success.
- Silent on Risk: While R-Squared indicates correlation with a benchmark, it overlooks other risks like sector concentration or volatility. Funds with high R-Squared values may still carry substantial risk unrelated to market movements, which R-Squared doesn’t account for, leaving certain risk factors unaddressed.
Conclusion
Investors won’t learn much about their portfolio from a single fund’s R squared. In addition, as R Squared is a technical and statistical tool, calculating it calls for a specific understanding. R squared for each fund must be determined in order to conduct a thorough comparative study of how the portfolio as a whole is performing.
When analysed along with beta or alpha, R Squared is favourable. While they shouldn’t be the only reference source, metrics like R Squared are useful boosters and accelerators for an investor’s study. Open your Demat account with Angel One today and start investing now!
FAQs
What R squared value for mutual funds is considered beneficial?
It is incorrect to categorise a R squared value as good or poor. The performance of an asset is not measured by this statistical instrument. It simply provides information on how much the asset has varied in response to changes in its benchmark.
Can I choose mutual funds with a low R squared value?
Avoiding mutual funds with low R squared values is generally recommended. However, consider a fund’s overall risk, return, strategy, and diversification for a balanced portfolio.
What is represented by a low R2 value?
If the R squared value is low, it indicates that the asset’s fluctuation can only be partially explained by the variation in its benchmark.
