Category : Investing Insights October 7, 20255 minutes read
R-squared in mutual funds is a key metric that helps investors understand how closely a fund’s performance aligns with its benchmark index. Simply put, it shows what percentage of a fund’s movements can be explained by changes in the market index it follows. A value close to 1 means the fund moves in sync with its benchmark, while a lower value indicates more independent performance.
The meaning of r squared becomes especially useful when you’re trying to figure out how much of a fund’s return is due to market trends versus active fund management. This applies to all types of mutual funds — whether they’re large-cap, mid-cap, debt, or sectoral.
The formula for r squared is based on regression analysis and compares the variation between the fund and the benchmark. It’s a valuable tool when comparing funds or evaluating metrics like Alpha and Beta.
So, what does R-squared really tell us? Put simply, it’s a percentage that shows how closely a mutual fund’s returns mirror its benchmark. A fund with an R-squared value of 0.95, for example, means 95% of its movements can be explained by its benchmark — be it the Nifty 50, BSE MidCap, or even a sector-specific index like Nifty IT or Nifty Pharma.
This matters whether you’re looking at large-cap mutual funds, sectoral themes like IT or Pharma, or even international funds. Understanding the meaning of R-squared can help you decide whether a fund is passively riding the market or actively trying to beat it.
This guide will explain the meaning of R-Squared in mutual funds, how it is calculated, and how investors can use it to assess the effectiveness of mutual funds in tracking their chosen benchmarks.
The formula of R-squared uses regression analysis to compare how much the fund’s returns move in relation to its benchmark. Here’s the formula:
R² = (Covariance of Fund and Benchmark Returns)² ÷ (Variance of Fund Returns × Variance of Benchmark Returns)
This tells you how well your fund tracks the market it’s supposed to follow.
Example:
Say you’re evaluating a mid-cap fund. If the monthly returns of the fund and the Nifty Midcap 150 show an R2 in mutual funds of 0.87, that means 87% of the fund’s performance is directly linked to the mid-cap index.
How to Interpret R-Squared in Mutual Funds
Now let’s talk about interpreting R-squared properly:
0.8 to 1.0: High correlation. Great for index funds, where the goal is to mirror the benchmark.
x
0.6 to 0.79: Moderate correlation. Common in actively managed funds that follow the market loosely.
Below 0.6: Low correlation. Often seen in global funds, thematic funds, or high-conviction portfolios that move independently.
For example, a large-cap index fund should ideally have a high R-squared value, while a flexi-cap fund with a more active strategy might sit in the moderate range. The key is knowing what to expect based on the fund’s objective.
Ready to make informed investment decisions? Start investing in mutual funds today and align your portfolio with market benchmarks for data-driven growth!
R-squared (R²) shows how closely a fund’s returns track its benchmark, with values from 0 to 1. A high R² (0.8–1.0) means strong correlation, ideal for index funds; moderate (0.6–0.79) suits active funds. Low R² (<0.6) suggests the fund moves independently, common in thematic or global strategies.
Let us understand the advantages of using R-squared:
Measures Benchmark Correlation
R-squared in mutual funds helps you assess how much a fund’s performance is linked to its benchmark — whether that’s a broad index like Nifty 50, a mid-cap index like Nifty Midcap 150, a sectoral benchmark such as Nifty FMCG, or even thematic indices. This makes R-squared a valuable tool across equity fund types — large-cap, mid-cap, small-cap.
Useful in Fund Comparison
When choosing between multiple funds in the same category — say, two large-cap funds or two international tech funds — R-squared offers a quick sense of which one closely tracks its benchmark. A higher R-squared means the fund’s performance is more in line with the index it aims to follow.
Aids in Evaluating Alpha and Beta
A reliable R-squared value adds meaning to other metrics like Alpha (excess returns over the benchmark) and Beta (volatility compared to the market). Without a strong correlation to a benchmark, Alpha and Beta may lose their relevance — making R-squared important for accurate performance evaluation.
While R-Squared has its own advantages, there are some limitations one should be aware of:
Relies on Historical Data
R2 in mutual funds is calculated using past performance. A large-cap fund might show high R-squared with the Nifty 50 today, but changes in fund strategy or market dynamics could impact future alignment. Similarly, a debt fund’s benchmark correlation can shift with interest rate cycles or portfolio adjustments.
Can be Misleading
A high R-squared value doesn’t guarantee good returns. For example, a fund tracking a sectoral index like Nifty Auto might have a near-perfect R-squared but still underperform if that sector struggles. In such cases, the fund’s alignment doesn’t equate to profitability.
Not a Risk Measure
Interpreting R-squared as a sign of safety would be a mistake. Even a fund with high R-squared, whether it’s tracking a stable bond index or a volatile small-cap index — doesn’t tell you how much risk or volatility is involved. It only shows correlation, not exposure to downside.
- R-squared in mutual funds measures how closely a fund’s returns track its benchmark index, such as the Nifty 50, Nifty Midcap 150, or Nifty FMCG.
- A high R-squared value (close to 1) indicates strong correlation with the benchmark and is useful for evaluating index funds, debt funds, or large-cap mutual funds.
- A moderate or low R-squared may be expected in actively managed funds, international mutual funds, or thematic funds like those investing in technology or pharma.
- R-squared helps investors understand how much of a fund’s performance is driven by market movements versus active fund manager decisions.
- It plays a critical role when interpreting Alpha (excess return) and Beta (volatility) by validating whether those metrics are benchmark-relevant.
- The formula for R-squared involves regression analysis, comparing the fund’s return variance with its benchmark’s, and is expressed as a value between 0 and 1.
- For example, a large-cap index fund should ideally show an R² close to 1, while a flexi-cap fund or a global equity fund might have a lower value due to broader strategies.
- R-squared is a helpful metric when comparing similar funds, like two mid-cap funds or two international equity funds, to see which more closely follows its intended benchmark.
- However, a high R-squared doesn’t guarantee high returns. A fund can closely track an underperforming index and still deliver poor results — such as a fund aligned with a struggling auto sector index.
- It’s also not a measure of risk — a fund tracking a volatile small-cap index may show high R-squared but still be high-risk.
- Since R-squared relies on historical data, any changes in the fund’s strategy or market conditions may alter its future alignment with the benchmark.
