Why R square of a fund should be seen in conjunction with Beta

There are various statistical tools used to measure the performance of mutual funds. Beta and R-squared are the two most used measurement tools. Although, they are used independently, using them in conjunction to each other will give a clear picture about the performance of the funds. First, let us understand what these terms are and what they measure.

Beta measures the sensitivity of a fund or its net asset value (NAV) movement to its benchmark. Therefore, if a mutual fund has a beta of one it mimics exactly the movement of the benchmark and is as sensitive or as volatile, as its benchmark, the beta of the market is considered as one. Hence, if a fund has a beta of 0.80 this means that if market moves by 100 per cent, the fund’s NAV will move by 80 per cent as it is less sensitive or volatile to the market. In another case, a fund with a beta of 1.20 will see its NAV moving by 120 per cent as it is more sensitive or volatile. This means that when the market has gone up by 10 per cent, fund’s NAV will move up by 12 per cent. Similarly, if the market drops by 10 per cent, the performance of the fund will drop by 12 per cent.

R-squared is another statistical tool that measures the percentage of a fund's NAV movement because of a benchmark. The value of R-square lies between 0-100. The value of 0 means that fund does not have any correlation to its benchmark at all. A mutual fund with an R-squared of 100 means the performance of fund matches exactly to its benchmark.

Why beta and R-squared should be used together

The beta of a fund depends upon the index used to calculate it. There might be a case where the index has no correlation with the movements in the funds. Thus, if the beta is calculated for mid-cap fund against a small-cap index, the resulting value will have no meaning. The reason being the fund will not move in tandem with the index.

Therefore, the beta should always be used in conjunction with R-square. The value of R-square shows how reliable the beta is. In a case, if the beta is 90 per cent, but R-square is just 10 per cent, it does not indicate much about the closeness in the movement of fund and benchmark. A higher R-square will give you a better picture of the beta value. Hence, you should use both tools simultaneously to arrive at any conclusion about the movement of the fund against its benchmark.