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 closely the performance of an asset can be attributed to the performance of a selected benchmark index.
- R-squared is measured on a scale between 0 and 100; the higher the R-squared number, the more correlated the asset is to its benchmark.
- Beta measures the volatility of an asset compared to its benchmark.
- A mutual fund with a beta of 1.0 is exactly as sensitive, or volatile, as its benchmark, whereas a fund with a beta of 1.20 is 20% more sensitive or volatile.
- Used in conjunction with alpha, R-squared and beta are valuable measures investors can review to determine how effective a fund manager is at capturing profit when a benchmark is also profiting.
R-Squared Measures Benchmark Correlation
R-squared is a measure of the percentage of an asset or mutual fund's performance as a result of a benchmark. Fund managers use a benchmark to evaluate the performance of a mutual fund. For example, a mutual fund might use the S&P 500 as its benchmark index. The goal of the fund would be to closely track or mirror the performance of the S&P 500 index.
R-squared measures the degree to which the fund's performance can be attributed to the performance of the selected benchmark index. R-squared 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.
Price charts that plot R-squared values are useful to help investors see the relationship between the movement of the mutual fund's price compared to its benchmark.
Beta Measures Volatility
Beta is a measure of a fund or asset's sensitivity to the correlated moves of a benchmark. Beta measures the systematic risk or volatility of an asset, security, or fund compared to its benchmark. Volatility is often associated with the wide swings in prices seen with securities in the stock market. Understanding volatility is important because high volatility indicates the price of a stock can change dramatically in either direction over a short time period.
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 Measures an Asset Manager's Performance
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 the manager's 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.
When using alpha to measure a manager's performance, it's important for investors to compare funds that are in the same asset class. Funds in different asset classes can have different levels of risk. For example, if an investor is interested in investing in a mutual fund that focuses on small-cap companies, then a comparison of similar mutual funds would generate a more meaningful alpha. Comparing small-cap companies to large-cap companies would be less meaningful because the risks associated with each type of company differ.
The Bottom Line
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.