R-Squared in Mutual Funds: Meaning, Formula & Uses

While selecting a mutual fund, one wants to know about the behaviour of that particular fund in relation to the overall market. Here comes the concept of understanding the meaning of R-squared in mutual funds. In simple words, it tells you the correlation of a particular fund with its benchmark index, such as Nifty 50 or Sensex.

It tells you how well the movement in a fund depends upon the benchmark index. It is always advisable to look at this ratio before buying any mutual fund. 

What Is R-Squared in Mutual Funds?

Let us look at this concept in more detail. R-squared is a score that sits on a scale of 0 to 100. Some platforms show it as 0 to 1, but the idea is the same.

The benchmark is chosen based on the fund category. For example, a large-cap fund will usually have the Nifty 100 or Sensex as its benchmark. The R-squared value in mutual funds tells you the percentage of a fund’s performance that matches the benchmark.

We can divide this into three simple ranges:

• High: A score around 85 to 100 means the fund moves very closely with its benchmark.
• Moderate: A score between 70-85 implies that the fund tracks the index reasonably well but does have its own mind.
• Low: A score less than 70 implies that the fund’s performance is quite different from the benchmark.

Please note that these values are assumptions only and are not set in stone. Every fund has its distinct behaviour due to its objective.

Why Does R-Squared Matter for Mutual Fund Investors?

Checking this number gives you a lot of clarity. Here is why it is very helpful for your investments.

• Checking How Closely a Fund Follows Its Benchmark: It gives you a reality check. You get to see if the fund is actually sticking to its stated plan.
• Telling Index Funds and Active Funds Apart: An index fund should have a score very close to 100. Active funds usually have a slightly lower score because the manager takes different bets.
• Knowing If Beta and Alpha Can Be Trusted: If R-squared is below 70, the beta and alpha numbers might be useless. The fund and the benchmark are just too different to compare.
• Avoiding Paying High Fees for a Fund That Just Copies the Index: Active funds charge higher fees. If an active fund has an R-squared of 98, it is just hugging the index. Perhaps you would do well purchasing an inexpensive index fund.
• Comparison of Similar Mutual Funds: It enables you to tell the difference between an aggressive and a conservative fund.

How to Calculate R-Squared in Mutual Funds

One might question how such a figure was calculated. The formula used to calculate it is straightforward: R-squared equals the square of the correlation between fund and benchmark returns.

The following method can be used for this calculation:

1. Collect the monthly NAV returns of the fund for a specific period.
2.  Collect the benchmark returns for the exact same period.
3.  Find the correlation between these two sets of numbers.
4.  Square that correlation number.
5.  Multiply by 100 to get a percentage.

Alternatively, one could also opt for using the RSQ formula in Excel/Google Sheets. All that needs to be done is entering “=RSQ (fund returns range, benchmark returns range)”.

To understand this better, let us consider an easy example. For instance, if the correlation between the fund and the benchmark is 0.90, all one needs to do is to multiply 0.90 by itself, which is 0.81. Multiplying by 100 gives 81 as the R-squared value.

However, it is unnecessary for most investors to calculate the R-Squared value manually since the value is provided by AMCs, factsheets, or research platforms.

Read Also: Indexation in Mutual Funds: Tax Rules

R-Squared vs Beta vs Alpha

R-Squared, Beta, and Alpha

Before going into detailed statistics, there are three main things that you must know. They are the R-squared, Beta, and Alpha. It is very useful to know the difference between them, especially in the case of R-squared in mutual fund analysis.

R-Squared indicates how much movement of a mutual fund can be attributed to its index. The Beta factor indicates how much a mutual fund moves up or down with respect to market movements. The Alpha factor gives the excess returns earned over an index.

Here is a simple comparison table to make things clear:

Feature	R-Squared	Beta	Alpha
What it measures	Link to benchmark	Volatility or risk	Extra returns generated
What it tells you	Does it copy the index?	How much does it swing?	Did the manager beat the market?
Ideal value	Depends on your goal	1 (same as market)	Higher is better

You must check R-squared first. If a fund does not follow its benchmark closely, its Beta and Alpha might not give you the right picture.

How to Read the R-Squared Value in Mutual Funds

Looking at the number is easy once you know what to expect. For index funds, you want a very high value. A score of 99 or 100 is great. It means the fund is doing its job of copying the market perfectly.

For active funds, a high value around 95 means the manager is playing it very safe. A lower value around 75 or 80 means the manager is taking active calls to try and beat the market. A low value below 70 means the fund is doing its own thing entirely. This is common for sector funds or thematic funds.

The time period really matters here. Always look at 3 years or 5 years of data. A 1-year score might be temporary and give you the wrong idea. 

Difference Between R-Squared and Adjusted R-Squared in Mutual Funds 

Basis	R-Squared	Adjusted R-Squared
What it measures	How much of a fund’s return variation is explained by its benchmark	R-Squared adjusted for the number of explanatory variables in a statistical model
Main purpose	Evaluates the relationship between a fund and its benchmark	Helps compare statistical models with different numbers of explanatory variables
Use in mutual fund analysis	Commonly used alongside Beta and Alpha	Less commonly used in basic mutual fund performance comparisons
Ease of understanding	Easier for beginners	More technical and typically useful in regression analysis

Where to Find R-Squared Data for Mutual Funds

You do not have to dig too deep to find this information online.

• AMC Factsheets and Websites: Every mutual fund house releases a monthly factsheet. You can find the R-squared data in the risk measures section.
• Research Websites: Web-based platforms such as Value Research, Morningstar, and Moneycontrol provide clear visibility of these metrics from the fund page.
• Your Investment Website: A decent trading app should highlight all these risk measures right at the start. You can check your mutual fund investments through the Pocketful website itself.
• AMFI and SEBI websites: You can refer to their websites for benchmark data.

Keep in mind that exact locations can differ from platform to platform. Just look for a section named “Risk Ratios” or “Portfolio Details”.

Benefits of Using R-Squared in Mutual Fund Analysis

Using this metric makes you a smarter and more aware investor.

• Better Fund Selection: You can pick funds that match your exact investment style.
• Clearer Idea of Fund Style: You will instantly know if a fund is an index hugger or a truly active player.
• Smarter Use of Beta and Alpha: You will only trust beta and alpha when the R-squared score is high enough to make sense.
• Better Portfolio Mix: You can avoid adding too many funds that behave the exact same way. This improves your diversification. 

Common Mistakes Investors Make While Using R-Squared

Sometimes, even experts make this mistake. Here is what you need to consider when reviewing your money.

High R-squared Equal to High Return Thinking: An R-squared value of 95 simply implies that it fits the index. This doesn’t mean anything about high returns.

• Comparing Funds with Different Benchmarks: You cannot compare a small-cap fund score with a large-cap index. It makes no sense mathematically.
• Focusing on the R-Squared Value Alone: The R-Squared value is only one of many things that must be considered.
• Looking at Only a Brief Span of Time: A 6-month value is completely meaningless for long-term planning. Look always at 3 or 5-year values.
• Falling for Fake Tips or Unofficial Links: Never share personal details or money with random Telegram groups promising high returns based on secret metrics 

Simple Tips to Apply R-Squared to Mutual Fund Analysis

This is how you can apply the R-Squared in mutual fund analysis:

• Ensure Proper Benchmark First: It is essential to make sure that the fund has been properly benchmarked to the proper index.
• Combining R Squared with other measures such as Beta, Alpha, Sharpe Ratio, and Standard Deviation: This would help you to obtain an accurate estimate.
• Compare Apple with Apple: Funds from the same category.
• Look at the Numbers Once or Twice a Year: It is not necessary to check it daily.
• Rely on Reliable Information Sources: You can use only the official websites of your broker/AMC.

Read Also: What is Mutual Fund Unit and How does it Work?

Conclusion

Risk metrics checking may seem somewhat boring at first sight. However, just a short review of these figures will help you to make a lot of things clear and feel confident about your decisions. Each single metric is a little piece of the story of your fund. 

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