R-squared is a statistical concept heard often in a financial context, often when discussing fund performance. In terms of a hedge fund or mutual fund, r-squared tells us how much of that fund’s performance is explained by movement in its benchmark portfolio. If the r-squre is 100, then all of that manager’s performance can be explained by movement in the benchmark, and that manager probably isnt worth investing with. However, if a fund has a low r-squared, say of 25, then the benchmark’s movements account for very little of the fund’s performance, and the manager may be worthwhile.
Q. So, this sounds pretty mysterious. What is it?
A. It’s another term from statistics that the financial industry uses. You see it all over the place in marketing materials, for both mutual funds and hedge funds. The best way to think about it is this: it explains how much of the portfolio’s performance is explained by the overall movements of the market.
Q. How is it measured? What numbers are we looking for?
A. You measure it on a scale of 1 to 100, with 100 meaning that all of the movement in the portfolio is explained by movement in the index. On the other hand, an r2 below 70 or so shows that the index and the portfolio are acting fairly differently.
Q. And the practical implication is…?
A. If a manager has a R squared of, say 95, his portfolio is acting a lot like an index. So that’s probably not something you want to pay a lot for, since you can get that almost free in an ETF.
Q. This whole discussion reminds me of our talk about beta. Is it the same thing?
A. It’s tricky, because they both describe things about how a stock or a portfolio relate to a reference index, but they aren’t the same thing.
Let’s review beta for a second. It measures the relationship between a stock or portfolio, and an index, this way: if a stock or portfolio moves in the same direction as the index, it will have a positive beta. But what that number is depends on the amplitude of the movement: if it moves twice as far as the index, its beta is 2; ten times, the beta is 10. So Beta tells you about comparative volatility.
Q. So, not the same, but they both describe correlations between a portfolio and an index. OK, bottom line, is this one of those terms we should ask about when looking at a fund manager?
A. Yes. Along with the basic returns (CAGR) and volatility ratios, a low R squared is something to look for. If you have that trifecta, and you see it over some period of time, you’re probably looking at real alpha… or at least a manager who’s been incredibly lucky.
And, anyway, it’s a good term to drop at your next cocktail party so people will think you’re a hedge fund expert.