R-squared is a score from 0 to 100. It shows how much a fund’s price moves because its benchmark index moves. A high score means the fund closely follows the index. It only shows how well the fund copies the benchmark’s pattern. It does not tell you if the fund made more or less money.
R-squared explains why a fund’s returns change. It shows what percent of a fund’s change comes from its benchmark. This is the only way to know if a fund acts like an index fund. The rules are clear. Funds must use a Total Return Index (TRI). This includes dividends, so you see the real results.
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Definition of R-squared
R-squared has a range from 0 to 100. It is the percent of a fund’s price change caused by the benchmark’s change. Funds that just copy an index will always have a score very close to 100. Funds where the manager makes unique choices will have much lower scores. This is a fact.
What does R-squared measure against a benchmark?
R-squared measures how well a fund’s returns “fit” with a benchmark’s returns. It shows how strong the connection is, not how big the price moves are. This number helps you understand beta and alpha. It shows if the benchmark is right for the fund. Without a good R-squared, beta and alpha are useless.
Link to the benchmark index
Mutual funds must use a TRI as their benchmark. This is the law. A TRI includes dividends, so it shows the total return, not just price changes. SEBI made this rule so you see the real picture. This makes the R-squared score very useful. It is the only correct way to measure.
Explains fit, not performance
Do not make this mistake. A high R-squared does not mean the fund manager is good or that the fund gives high returns. It only means the fund moves like its benchmark. Alpha shows skill and extra return. A low R-squared does not mean the fund is bad. It just shows the manager is making different choices and not following the benchmark.
Data inputs and lookback period
To get the R-squared number, you must look at the fund’s and the benchmark’s returns. You always use monthly data for the last 36 months. This is the standard way to calculate alpha, beta, and R-squared. Many websites also find a fund’s “best-fit” index. They test many benchmarks and choose the one with the highest R-squared. This shows you how the fund truly acts.
Daily vs monthly returns effect
The data you use matters. Daily data gives you different numbers than monthly data. Daily data has a lot of noise. You must use monthly data for these numbers. Always use the same data type to compare funds.
Rolling vs static calculation
Always check R-squared over rolling time periods. Look at it for every 36-month window to see how the fund changes. A single number from one period is useless. It doesn’t show the full story. The rolling method is the only way to see if a fund’s link to its benchmark gets stronger or weaker.
Typical value ranges and meaning
90–100: index-like behavior A score this high means the fund’s returns follow the benchmark exactly. You must see this for index funds or “closet indexers.”
Below 70: active bets dominate A score in this range shows the fund is very different from its benchmark. The manager makes big, independent decisions. This is a clear sign of an active fund.
Interpreting R-squared
R-squared is only useful when the benchmark matches the fund’s goal. You must also look at the right time period for the fund’s style. Use it as a tool to check the benchmark. It is not a tool to predict performance.
How is R-squared calculated for funds?
You get the R-squared number by comparing a fund’s returns to its benchmark’s returns. The standard way is to use monthly data for the last three years. The best services test many benchmarks. They show you the one with the highest R-squared. That is the true “best-fit” benchmark.
Inputs: fund and benchmark returns
The math uses the fund’s and benchmark’s returns. You must use the “excess return,” which is the return above the risk-free rate. This separates market returns from fund-specific returns.
Coefficient of determination context
R-squared is technically the “coefficient of determination.” It shows how much of a fund’s risk comes from the benchmark. A high R-squared means the benchmark causes most price changes. A low R-squared means other things drive the fund’s returns.
High R-squared: when it helps
Index funds and closet indexers
A high R-squared is exactly what you want for an index fund. It is proof the fund is doing its job. A score of 95% or more shows a fund is a true index tracker, especially with low tracking error.
Style consistency and predictability
A high score also shows a fund has a stable style. It moves predictably with its benchmark. This gives you confidence in its beta and alpha. When R-squared is high, the beta score is trustworthy. It shows how the fund reacts to the market.
Low R-squared: when it helps
Active strategies and diversification
A low R-squared is a good thing for active funds. It shows the fund is different. It can protect your money from benchmark risks. Funds that make unique bets or have a flexible plan must have a low R-squared. It’s proof they are truly active.
Unique bets and manager discretion
A low score shows the fund’s returns come from the manager’s choices, not the benchmark. When you see a low score, you must look deeper into the fund’s plan. In these cases, alpha and beta are meaningless because the benchmark is not relevant.
R-squared vs beta and alpha
R-squared, beta, and alpha work as a team. Each one tells you something different. R-squared shows if the benchmark is relevant. Beta shows how sensitive the fund is to the market. Alpha shows the extra return you got. You must use all three together.
| Metric | What it conveys | When it’s reliable |
|---|---|---|
| R-squared | Shows how closely the fund follows the benchmark (0–100). | Only works if the benchmark is correct for the fund. |
| Beta | Shows how much the fund moves when the benchmark moves. | Only makes sense when R-squared is high. |
| Alpha | The extra return you get for the risk taken. | Only means something if R-squared is high and the benchmark is correct. |
Complementary, not interchangeable
A high beta is misleading if the R-squared is low. R-squared is the first thing you check. It tells you if you should pay attention to beta and alpha. You must use these numbers together to get the full story.
Use together for fuller context
You must combine R-squared, beta, and alpha with the fund’s holdings and goal. This is the only way to know if returns come from the market or the manager’s picks. A high R-squared and high beta mean the fund is tied to the market. A low R-squared shifts the story toward unique exposures.
Common pitfalls and misuses
Confusing fit with skill
R-squared never measures skill. It only measures how much a fund copies a benchmark. Alpha measures skill. But alpha is only useful if the R-squared is high. This shows the benchmark is correct.
Ignoring period and regime shifts
Looking at one fixed time period is a huge mistake. It hides important changes. You must use rolling time periods to see when a fund’s relationship with its benchmark changes. Always compare funds using the same time window to get a clear, fair view.
Practical screening and comparison tips
Match the right benchmark first
First, make sure the benchmark matches the fund’s goal. You must use TRI benchmarks to compare total returns fairly. Using the right benchmark is the only way to get a meaningful R-squared, beta, and alpha.
Compare peers over same window
When you compare funds, use the same time period and data frequency. Monthly is the standard. A 36-month lookback is what you should use. Comparing funds with different data or time periods is a complete waste of time. It will give you the wrong answers.
FAQ
Is a higher R-squared always better?
No. A higher score is not always better. It just means the fund copies its benchmark. This is great for index funds. For active funds, a lower score is better. It shows the manager makes unique choices. R-squared is a tool to check fit, not quality.
What is a good R-squared value?
For index funds, you must see a score near 100. For active funds, a score between 70 and 100 shows strong benchmark movement. A score below 70 shows the fund is very different from its benchmark.
Can R-squared predict future returns?
No. R-squared only tells you about the past. It gives you zero guarantee about the future. You use it to understand what a fund did, not to guess what it will do.
Should R-squared guide fund selection?
You must use R-squared to check benchmark alignment and style. Then you can interpret beta and alpha. Never pick a fund just because of its R-squared score. Always start with the fund’s TRI benchmark. This is the only way to be accurate.
