Beta and R-squared are two related, but different, measures. A mutual fund with a high R-squared correlates highly with a benchmark. If the beta is also high, it may produce higher returns than the benchmark, particularly in bull markets. R-squared measures how closely each change in the price of an asset is correlated to a benchmark. Beta measures how large those price changes are in relation to a benchmark. Used together, R-squared and beta give investors a thorough picture of the performance of asset managers.
R-Squared Measures How Performance Matches a Benchmark
R-squared is a measure of the percentage of an asset or fund's performance as a result of a benchmark. It is reported as a number between 0 and 100. A hypothetical mutual fund with an R-squared of 0 has no correlation to its benchmark at all. A mutual fund with an R-squared of 100 matches the performance of its benchmark precisely.
Beta is a measure of a fund or asset's sensitivity to the correlated moves of a benchmark. A mutual fund with a beta of 1.0 is exactly as sensitive, or volatile, as its benchmark. A fund with a beta of 0.80 is 20% less sensitive or volatile, and a fund with a beta of 1.20 is 20% more sensitive or volatile.
Alpha is a third measure, which measures asset managers' ability to capture profit when a benchmark is also profiting. Alpha is reported as a number less than, equal to, or greater than 1.0. The higher a manager's alpha, the greater his or her ability to profit from moves in the underlying benchmark. Some top-performing hedge fund managers have achieved short-term alphas as high as 5 or more using the Standard & Poor's 500 Index as a benchmark.
The alpha and beta of assets with R-squared figures below 50 are thought to be unreliable because the assets are not correlated enough to make a worthwhile comparison. A low R-squared or beta does not necessarily make an investment a poor choice, it merely means its performance is statistically unrelated to its benchmark. (For related reading, see: Understanding Volatility Measurements.)