What Is R-Squared?
R-squared (R²) measures the percentage of a portfolio's variance that can be explained by movements in a benchmark index. R² ranges from 0 to 1 (or 0% to 100%). An S&P 500 ETF will have an R² near 1.0 with the S&P 500 benchmark; a market-neutral fund will have an R² near 0.
High R² means the portfolio moves in lockstep with the benchmark — most of its return comes from market exposure (beta), not from skill (alpha). Low R² means the portfolio's returns come from elsewhere, which could mean genuine alpha or could mean exposure to a different factor.
R² gives context to alpha and beta. An alpha of 3% from a portfolio with R² of 0.95 is meaningful (small but consistent edge over the benchmark). The same 3% alpha from a portfolio with R² of 0.20 might be noise — the benchmark isn't the right comparison. Always look at R² before judging alpha.
Related terms
- Alpha — Return earned above a benchmark, adjusted for risk — a measure of skill.
- Beta — Sensitivity of an asset's returns to overall market returns.
- Sharpe Ratio — Risk-adjusted return — the excess return per unit of volatility.
- Diversification — Spreading investments across different assets to reduce risk.