Investing
R-squared
correlation
R-squared in mutual fund analysis
R-squared measures the proportion of a mutual fund’s return variability that is explained by its benchmark index, ranging from 0 to 100 (or 0 to 1). It indicates how closely the fund’s returns track the benchmark.
Interpretation
| R-squared | Interpretation |
|---|---|
| 85-100 | Closely tracks benchmark (typical for index/closet-index funds) |
| 70-85 | Reasonable benchmark alignment |
| 50-70 | Moderate benchmark alignment |
| < 50 | Weak benchmark alignment |
For Indian mutual funds:
- Index funds: R-squared typically 99+ (very close tracking).
- Active large-cap funds: R-squared 85-95 typically.
- Mid/small-cap funds: R-squared 70-90.
- Sector/thematic funds: R-squared can be lower (60-80).
Use cases
Beta interpretation
R-squared determines whether beta is meaningful:
- High R-squared (>70): Beta is statistically reliable.
- Low R-squared (<70): Beta is less reliable; fund moves independently.
Closet indexing detection
For actively-managed funds with high R-squared (>95):
- The fund essentially tracks the benchmark.
- High TER paid for very-close-to-index performance.
- Considering passive alternative may be more cost-efficient.
Diversification assessment
Low R-squared funds add diversification value (they move differently from broad market).
See also
- Mutual funds in India
- Alpha mutual fund
- Beta mutual fund
- Sharpe ratio
- Information ratio
- Tracking error
- Std deviation MF
- Active vs passive equity in India
External references
References
- CFA Institute curriculum on portfolio analytics.
- Statistical literature on R-squared in finance.