Thursday, February 24, 2005

Know your R2

Investment News reports that "at the end of 2004, 27.6% of all large cap funds had a 3 year R2 of .95 or higher relative to the Standard and Poors 500 fund..making them closet index funds". This statistic sounded a little high though the trend is not surprising so I decided to do a quick bit of research on this .

First of all R2 or"R squared" is a statistical measure of how closely correlated a fund's performance is with the performance of its benchmark. R2 values range from 0 to 1. 0 indicates no correlation while 1.0 indicates perfect correlation to the market. In CFA school we were taught to interpret R2 as follows: " The R2 indicates the % of a fund's performance that can be explained by the performance of the market". The collorary is that 1-R2 = the amount of performance that can be explained by active management. So you can see that an investor paying active management fees (averaging 1.47% according to the article) for a fund with an R2 of 95% should feel cheated when 95% of the fund performance can be explained by market performance available in index fund or ETF form for 1/10 the price.

I ran screen on all Large Cap Value funds using Morningstar data to look at the characteristics of all the funds with R2 of .95 or higher. I found 35 of these funds out of approximately 375 total Large Cap Value funds. My screen includes any fund only once regardless of whether it has multiple share classes while the article may include all share classes for every fund. My sample indicates about 10% of funds are indexers/closet indexers. To maximize the sample size I used an R2 measure form 2/2203 to 12/2004.

The average annualized return of the high R2 funds was 24.46% versus a Russell 1000 Value return over the same period of 25.79%. This is annualized under-performance of 1.33%. It may not surprise you to know that the average fund expense for high-R2 sample was 1.10%, accounting for the majority of that underperformance. The average excess return for the High R2 funds was about -1% ( with a max at +4% and a min at -5%). Tracking error (volatility of excess returns was a very low 1.95%. Average Beta (measure of relative market risk where 1.0 = market risk) for these funds was .99 as should be expected.

What does this tell us? That a number of investors are getting picked off by paying too much for funds sold as actively managed whose returns are largely driven by the market. It is very interesting to note the composition of the fund families associated with the majority of these high R2 funds. Each large mutual fund complex seems to have 1 while the wirehouses and insurance companies predominate the remainder. My thesis is that these funds are sold to the retail marketplace and are held in small 401(k) plans where minimizing the chances of benchmark underperformance maximizes retention and profitability for these firms.

1.10% is a very high price to pay for the market! If you have fiduciary responsibility for funds, understand how they correlate to their market benchmarks (by the way, low R2 can also mean you are using a bad performance benchmark) and, where possible, don't pay up to get systematic market exposure.

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