r squared
R Squared shows how much of a fund or stock's movement can be explained by its benchmark, rather than by its own quirks.
In plain English
Two okada riders can both get you to Yaba in twenty minutes, but one follows the main road every single time while the other cuts through side streets, potholes, and market crowds depending on his mood. If you wanted to predict where either man would be at any moment, the first rider is easy. He tracks the main road so closely that knowing the road tells you almost everything about him. The second rider is a mystery. The road might explain some of his movement, but a lot of it is just him.
R Squared does the same job for a fund or a stock, except the main road is a benchmark like the NGX All Share Index or the FTSE 100 in the United Kingdom. It is a number between 0 and 100 that tells you how much of an investment's ups and downs can be explained by the ups and downs of its benchmark. A fund with an R Squared of 90 is behaving like the first okada rider. It is closely tracking the road, so if you know how the index moved, you have a good guess of how the fund moved.
A fund with an R Squared of 30 is the second rider. The benchmark barely explains it. Its returns are driven by something else entirely, maybe the manager's own stock picks, maybe sector bets that have nothing to do with the broad market.
This matters for a Nigerian investor comparing two mutual funds that both claim to track the NGX All Share Index. One might genuinely mirror it, the other might be dabbling far outside it while still calling itself an index style fund. It also matters for someone in London or abroad sending money home into a Nigerian equity fund, wanting to know whether the fund's performance is really tied to the market they think it is tied to, or whether it is going off script.
R Squared does not tell you if the returns are good or bad. It only tells you how tightly the investment and its benchmark are dancing together.
A Lagos based equity fund has an R Squared of 85 against the NGX All Share Index. That means 85 percent of the fund's monthly ups and downs can be explained by the index's own ups and downs, leaving only 15 percent to the manager's own decisions.
Questions people ask
Is a high R Squared always a good thing?
Not necessarily. A high R Squared just means the investment moves closely with its benchmark. If you are paying a fund manager high fees expecting original stock picking, a very high R Squared close to 100 might mean you are basically paying extra for what an index fund would give you anyway.
What R Squared number should I look for?
There is no single correct number, it depends on what you want. If you want a fund that closely tracks the market, look for something above 85. If you want a manager who is genuinely doing something different from the benchmark, a lower R Squared, alongside other measures like risk adjusted return, tells a fuller story.
Does R Squared work for individual stocks too, more than funds?
Yes. You can measure a single stock's R Squared against an index to see how much of its price movement is explained by the broad market versus company specific news, like a Dangote Cement announcement that has nothing to do with the wider NGX All Share Index.
Last reviewed