What Is R-Squared Investing?
A mutual fund is a basket of investments, such as stocks and bonds, that you can buy shares in. R-squared is a measurement of a fund's performance that gives you a quick way to determine how closely your mutual fund performance tracks with the Standard & Poors 500 index. R-squared investing, then, can mean investing to mirror stock index performance or diversifying your investments so that part of your portfolio does not track stock index performance.
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Interpreting R-Squared
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R-squared is a statistic presented as a number between 0 and 100. The higher the R-squared number your mutual fund has, the more it will behave like the S&P 500. If you own a mutual fund that has an R-square of 100, your fund shares will rise and fall in perfect unison with the S&P 500. If it has an R-square of 50, only 50 percent of its price moves can be explained by the movement of the S&P.
Mirroring Index Performance
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Mutual funds can either be actively managed by a professional money manager, who makes buy and sell decisions for investors, or designed to mirror a stock index, such as the S&P 500. Most actively managed funds have historically underperformed unmanaged index funds by an average of 2 percent per year, according to "The Motley Fool." Thus, it can pay to buy a mutual fund that has a high R-squared number, indicating it will match market index performance more closely.
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Moving Away From Indexes
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The stock market, including the S&P 500, can experience steep declines during economic downturns. Investing some of your money in mutual funds that have a low R-squared number can offer a way to diversify your money so that market downturns have less impact on your overall investment portfolio. Bond funds, for example, have low R-squared numbers and tend to rise when the stock market is falling, according to "USA Today." Other types of funds that are not correlated to the S&P 500 include natural resource funds, such as oil and gold, utility funds and international income funds.
Avoiding Heavy Management Fees
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Actively managed mutual funds typically charge higher fees than index funds because index funds only charge fees to cover their administrative costs, while managed funds charge a management fee in addition to administrative costs. Some managed mutual funds are actually closet index funds, which means they charge you a management fee, but the manager of the fund designs the fund after a market index. If a managed fund you own has a high R-squared number, it may be a closet index fund, which means you are likely paying higher fees than you would if you replaced it with a low-cost index fund.
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