What is R-Squared?
R-squared measures how closely the movements of a bond mutual fund or bond ETF are connected to its benchmark bond index. The number is measured on a scale of 1 to 100 and can be thought of as a percent. When looking at a fund on Morningstar, you can can find the R-squared number in the Rating and Risk section.
Index Funds are designed to track a particular index as closely as possible. Therefore, if you are investing in a bond index fund, the R-squared number will be very close to 100. For example, the Vanguard Total Bond Market ETF (BND) has an r-squared number of 99.2 for the last 3 years when compared to its benchmark index. Ironically, if you invested in an index fund that shorted a bond index, the R squared number would also be close to 100. There is still a direct relationship (although negative) between the fund’s movements and the index.
What does R-Squared Tell me About My Bond Funds?
R-squared is a useful measure of how actively a fund or ETF is managed. Put another way, the lower the R-squared number, the greater the portion of the fund’s performance is being derived from fund’s style or manager’s investment decisions. The PIMCO Total Return Fund has an R-squared number of 41 for the last three years, versus the intermediate bond fund category which has a number of 61. This means that when you invest in the PIMCO Total Return Fund, your returns are likely to be very, very different than the index. In the case of the PIMCO Total Return Fund, the fund’s performance is going to be farther away from the overall bond market than other intermediate term bond funds. This can be a good thing or a bad thing depending on how the fund’s manager, Bill Gross performs.
What’s the Bottom Line?
A low R-Squared number means that you are taking a risk on the portfolio manager’s ability. The lower the R-Squared number is the more trust you are placing in a portfolio managers skills to beat the market. This can be a good or a bad thing depending on how well that manager performs.