What Does R-Squared Reveal?
In Part 2 of our series on modern portfolio theory, we discuss how R-squared can determine the usefulness of other MPT statistics.
Question: Last week you noted that the beta statistic may be irrelevant if a fund has a limited correlation with an index. How would I know how well my fund is correlated with an index?
Answer: In last week's article, we went over how beta and other modern portfolio theory statistics can be a helpful way to assess an investment's risk/return characteristics. A fund's beta gauges an investment's sensitivity to movements in a market index. When a market index is up on a given day, for example, the beta looks at whether the fund has a tendency to gain more or less than that benchmark.
But MPT statistics like beta also have limitations, particularly that they're relative measures. That means their validity depends on whatever benchmark an investment is being measured against and the degree of correlation between that investment. If a fund has a very high beta but a limited correlation with the index on which that beta statistic depends, investors should discount that data point accordingly. To help demonstrate the extent to which a fund's performance tracks that of a benchmark, Morningstar provides a statistic called R-squared.
Esther Pak does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.