R-Squared

R-Squared (R²) measures the percentage of a fund's returns that can be attributed to movements in its benchmark index. It indicates how closely a fund tracks its benchmark.

Interpreting R-Squared:

R² Value	Interpretation	Example
95-100%	Very high benchmark dependency	Index funds, closet indexers
85-95%	High correlation to benchmark	Most large-cap active funds
70-85%	Moderate — some active management	Sector-focused funds
40-70%	Low — significantly different	Hedge funds, alternatives
0-40%	Very low — minimal relationship	Market-neutral strategies

Using R-Squared with Beta:

• High R² makes beta meaningful (the relationship is reliable)
• Low R² makes beta unreliable (too much unexplained variation)
• Rule: only trust beta when R² > 70%

R-Squared for Fund Selection:

If You Want	Look For	R² Range
True index tracking	Passive index fund	98-100%
Genuine active management	Active fund	70-90%
Diversification benefit	Alternative strategy	< 50%
Closet indexer detection	Active fund charging high fees	> 95% (warning sign)

Closet Indexer Alert: If an active fund has R² > 95% and charges 0.8%+ in fees, you're essentially paying for index-like returns. Switch to a real index fund at 0.03-0.10% fees.

Formula: R² ranges from 0 to 1 (or 0% to 100%). It equals the square of the correlation coefficient between the portfolio and benchmark returns.