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What is R-Squared in Mutual Funds?

By Bajaj Broking Team

June 25, 2025

4 mins read

Share Market

R-Squared is a statistical measure that helps investors understand how closely a mutual fund’s performance aligns with a benchmark index. It provides insight into whether a fund's movements are significantly influenced by its benchmark. However, it is essential to note that R-Squared does not indicate the quality or profitability of a mutual fund. Instead, it simply helps in understanding the extent to which a fund’s returns correlate with a given index.

For instance, if a mutual fund has a high R-Squared value, it means its returns closely mirror the benchmark. Conversely, a lower R-Squared value suggests that the fund’s performance is not significantly impacted by the benchmark’s movements. This is particularly useful when comparing actively managed funds with passive funds like index funds.

Investors should remember that R-Squared is a supportive metric rather than a decisive one. It should be used alongside other indicators such as beta and alpha to get a comprehensive view of a mutual fund’s performance. A high R-Squared in mutual funds might be desirable for some investors, while others may prefer funds with lower R-Squared values if they seek diversification beyond the benchmark.

R-Squared is a helpful analytical tool in investment decision-making. However, it does not measure risk or return directly. Instead, it serves as a guiding factor in understanding how a fund moves in relation to its benchmark, making it useful for investors aiming to assess the behaviour of their investments.

How to read an R-Squared for a fund?

Understanding R-Squared in mutual funds is crucial for investors to interpret a fund’s correlation with a benchmark. A high R-Squared value, closer to 100, indicates that the fund closely follows the index’s movements. This is typically seen in index funds, which aim to replicate benchmark returns as accurately as possible.

On the other hand, actively managed equity funds may have a lower R-Squared value because fund managers seek to outperform the benchmark rather than merely mimic it. A lower R-Squared does not necessarily mean poor performance; rather, it signifies that the fund follows a different strategy than the benchmark, offering diversification benefits.

Investors should not solely rely on R-Squared when selecting funds. It should be analysed alongside other performance metrics like beta and alpha. If a fund has a low R-Squared but a high alpha, it indicates strong performance independent of the benchmark, which might be beneficial for diversification.

How does R-Squared work?

R-Squared value ranges from 0 to 100 and helps investors understand how much of a mutual fund’s movements can be explained by changes in its benchmark index. Below is a breakdown of how it works:

R-Squared of 100
: This means that the fund’s performance is completely explained by the movements of the benchmark index. For example, an index fund that invests solely in Nifty 50 stocks will likely have an R-Squared close to 100.
R-Squared above 85
: A value in this range suggests a strong correlation with the benchmark. Such funds usually mirror the index’s performance, making them suitable for investors seeking index-linked returns.
R-Squared between 50 and 85
: Indicates a moderate correlation with the benchmark. Actively managed mutual funds typically fall into this category, as they aim to outperform the index while still maintaining some correlation.
R-Squared below 50
: A low R-Squared value suggests that the fund’s performance is largely independent of the benchmark. This might be due to a diversified or alternative investment strategy.
R-Squared of 0
: Implies no correlation between the fund and the benchmark index, which is uncommon in mutual funds but possible in niche investment strategies.

Understanding how R-Squared works enables investors to assess whether a fund aligns with their investment goals and risk tolerance.

How to calculate R-Squared?

R-Squared is calculated using statistical measures such as correlation and standard deviation. Below are the key steps:

Determine the covariance between the benchmark index and the fund’s returns.
Calculate the standard deviation of both the benchmark and the fund.
Find the correlation using the formula:
Correlation = Covariance (Benchmark & Portfolio) / (SD of Portfolio * SD of Benchmark)
Square the correlation value to obtain R-Squared.
Express R-Squared as a percentage within the 0-100 range.

R-Squared Formula:

R-Squared = (Correlation Coefficient)^2

Here, the correlation coefficient is a measure of the relationship between the mutual fund’s returns and its benchmark index. The formula incorporates covariance (a measure of how two variables move together) and standard deviation (which measures volatility).

For investors, understanding this formula helps in assessing whether a mutual fund’s performance is benchmark-driven or influenced by other factors. When used correctly, R-Squared provides valuable insights that aid in portfolio analysis and fund selection.

R-Squared Values in Investment Analysis

Understanding the r squared value in investment analysis is essential for evaluating how closely a mutual fund follows its benchmark. A high r squared value suggests that the fund's performance is largely influenced by the benchmark, whereas a low value indicates lesser correlation. While this metric does not predict returns, it helps investors assess whether a fund aligns with their risk and return expectations.

For investors considering diversified portfolios, R-Squared in mutual Funds can provide insights into how much of a fund’s movement is attributable to market trends. However, it should be used alongside other key metrics like beta and alpha to gain a well-rounded view of a fund’s potential performance.

The Significance of R-Squared in Mutual Fund Performance

What is R-Squared and why does it matter in mutual fund performance? R-Squared is particularly useful in assessing whether actively managed funds provide value beyond simply mimicking an index. A high r squared value indicates strong alignment with the benchmark, which is ideal for index funds, while a lower value may suggest active management.

For investors in India, particularly those looking at long-term wealth creation through mutual funds, understanding R-Squared in mutual Funds can aid in selecting funds that align with their investment goals. For example, actively managed funds with moderate R-Squared and strong alpha can indicate skilled fund management capable of outperforming benchmarks.

Additionally, investors comparing mutual funds with other financial instruments, such as fixed deposits or even instruments related to recurring deposit meaning, can use R-Squared to make informed decisions. This metric ensures that they understand the extent of market correlation in their investment choices.

Limitations of the R-Squared Metric

While R-Squared in mutual Funds is useful, it has certain limitations. It does not indicate whether a fund is a good investment or whether it will generate high returns. It simply shows how much of a fund's movement can be attributed to its benchmark index.

Key Limitations:

R-Squared does not measure risk-adjusted returns.
A high r squared value does not mean the fund is superior; it just shows correlation.
It should always be used in conjunction with beta and alpha for a holistic assessment.

Strategies to Enhance R-Squared Values

Improving the r squared value in a mutual fund portfolio involves strategic fund selection and portfolio diversification. Investors looking for higher correlation with benchmarks should focus on index funds or ETFs, which naturally exhibit high R-Squared.

For those aiming for a balanced portfolio, diversification strategies can help achieve optimal R-Squared in mutual Funds. This includes:

Choosing Index Funds
: These funds aim to replicate benchmark performance, resulting in high r squared value.
Blending Active and Passive Investing
: A mix of active and passive funds can ensure that investors benefit from skilled management while maintaining market correlation.
Sector-Based Allocation
: Allocating funds based on specific industry sectors can influence R-Squared, depending on how closely those sectors follow the overall market trends.
Rebalancing Portfolios Regularly
: Ensuring that investments remain aligned with financial goals and market conditions can optimise R-Squared.

Ultimately, what is r squared in mutual fund investments should be understood in conjunction with other performance indicators. While it helps gauge fund correlation, investors should also assess risk factors and potential returns before making decisions.

Adjusted R-Squared: A Better Alternative

While R-Squared in mutual funds is a useful statistical tool, its reliability can sometimes be questioned due to the inclusion of multiple variables. Adjusted R-Squared offers a refined version of the R-Squared value, making it a better alternative in many cases. By considering the number of independent variables used in the model, adjusted R-Squared accounts for the diminishing returns that extra variables may introduce.

For investors, this means that adjusted R-Squared provides a more precise measure of how closely a mutual fund aligns with its benchmark. If additional variables do not significantly improve the predictability of fund performance, adjusted R-Squared will decrease, indicating a more accurate measure. This adjustment ensures that an investor does not overestimate the reliability of a fund’s correlation with its benchmark, making it a more effective analytical tool.

Comparing R-Squared with Adjusted R-Squared

While R-Squared measures the correlation between a fund’s performance and its benchmark, adjusted R-Squared refines this by factoring in the number of independent variables considered. This makes adjusted R-Squared more reliable in cases where multiple variables are involved.

Key Differences Between R-Squared and Adjusted R-Squared

Factor	R-Squared	Adjusted R-Squared
Definition	Measures how much of a fund’s movements can be explained by its benchmark.	Adjusts R-Squared value to account for additional independent variables.
Accuracy	Can overestimate correlation if too many variables are included.	Provides a more precise correlation measure.
Best Used For	Analysing broad trends in fund performance.	Fine-tuning fund correlation models.
Limitation	Does not account for redundant variables.	Reduces impact of unnecessary variables, ensuring better accuracy.

This comparison shows that while R-Squared in mutual funds is useful, adjusted R-Squared offers a clearer picture by preventing misleading conclusions from excessive variables.

When to Use R-Squared or Adjusted R-Squared?

The choice between what is R-Squared and adjusted R-Squared depends on the level of precision required in analysis.

Use R-Squared when you need a broad measure of how closely a fund follows its benchmark.
Use adjusted R-Squared when multiple factors influence fund performance and a refined correlation measure is needed.
Investors assessing index funds can rely more on R-Squared value, as these funds inherently track benchmarks closely.
For actively managed funds, adjusted R-Squared provides better insights, as these funds do not strictly mirror a benchmark.

The Relationship Between R-Squared and Beta

What is R-Squared in mutual funds if not used in conjunction with other metrics? This is where beta comes in. Beta measures the risk and volatility of a fund compared to its benchmark, while R-Squared value assesses how well the fund’s movements are explained by the benchmark. Analysing both together gives investors a comprehensive risk-return profile.

A fund with a high R-Squared value and a beta close to 1 suggests that the fund moves almost identically to its benchmark. This is common in index funds or passive investment strategies. In contrast, if a fund has a high beta but low R-Squared, its volatility is not necessarily due to benchmark fluctuations, meaning it could be influenced by other factors such as sector allocation or stock selection.

For example, a mutual fund with a beta of 1.3 and R-Squared in mutual funds of 90% indicates that the fund is more volatile than the benchmark but still follows its trends closely. However, if the same fund had an R-Squared of 40%, its volatility might be driven by non-benchmark-related factors, making direct benchmark comparisons less meaningful.

A lower R-Squared value does not necessarily mean poor performance. It may indicate an actively managed fund that takes independent positions rather than following an index. However, in such cases, investors should also evaluate alpha to determine if the excess risk is justified by better returns.

Thus, while R-Squared helps establish correlation, beta provides insights into risk, and using them together enhances portfolio assessment.

Drawbacks of R-Squared

While R-Squared in mutual funds is useful, it has limitations that investors should consider. One key drawback is that R-Squared value does not measure fund performance. A high R-Squared only indicates that a fund tracks a benchmark closely, but it does not confirm whether the fund is generating strong returns.

Another drawback is that R-Squared is less relevant for funds that aim to outperform benchmarks rather than mirror them. Actively managed funds with a lower R-Squared value may still provide superior returns, even if their movements do not strongly correlate with the benchmark. Relying solely on R-Squared in mutual funds could lead to overlooking valuable investment opportunities.

Final Thoughts

What is R-Squared, and should investors rely on it alone? While R-Squared in mutual funds is a valuable metric, it should not be the sole factor in investment decisions. It merely shows the extent to which a fund's performance is linked to a benchmark, without indicating whether the fund is a good investment.

For a well-rounded assessment, investors should use R-Squared value alongside beta, alpha, and other financial ratios. Understanding how these metrics interact will provide a more holistic view of a fund’s potential, helping investors make more informed decisions.

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