R-squared

The problem with beta is that it depends on the index used to calculate it. It can happen that the index bears no correlation with the movements in the fund. Thus, if beta is calculated for large cap fund against a mid-cap index, the resulting value will have no meaning. This is because the fund will not move in tandem with the index. Due to this reason, it is essential to take a look at a statistical value called R-squared along with beta. The R-squared value shows how reliable the beta number is. R-squared values range between 0 and 100, where 0 represents the least correlation and 100 represents full correlation. If a fund's beta has an R-squared value that is close to 100, the beta of the fund should be trusted. On the other hand, an R-squared value that is close to 0 indicates that the beta is not particularly useful because the fund is being compared against an inappropriate benchmark.

Thus, an index fund investing in the Sensex should have an R-squared value of one when compared to the Sensex. For equity diversified funds, an R-squared value greater than 0.8 is generally accepted to mean that the underlying beta value is reliable and can be used for the fund.

R-squared measures how much of the fund’s return can be explained by the market movements. It does this by measuring how closely the fund’s performance tracks that of the benchmark index. The R-squared of an index fund, investing in same securities and in the same weightage as the index, will be one. The values for other funds will be lower depending upon the correlation with the benchmark index.  The beta of a fund has to be seen in conjunction with the R-squared for understanding the risk of the fund. If a fund has a high R-squared, it makes the beta a valid measure. A figure of 0.8 or higher for the R-squared is considered adequate to give credence to the beta. The lower the R-squared the less reliable is the beta.

It is essential to take a look at a statistical value called R-squared along with beta. The R-squared value shows how reliable the beta number is. It varies between zero and one. An R-squared value of one indicates perfect correlation with the index. Thus, an index fund investing in the Sensex should have an R-squared value of one when compared to the Sensex. For equity diversified funds, an R-squared value greater than 0.8 is generally accepted to mean that the underlying beta value is reliable and can be used for the fund. Beta and R-squared should thus be used together when examining a fund's risk profile. They are as inseparable as risk and return.