Welcome back to another edition of Foolish mutual fund basics. This time, we're leaving behind our exotic tour of fund categories for the hip hideout of the R-squared ratio. Ready to get started? Good.
What it is
Most days, I'm an enthusiastic investor. When I'm not, it's usually because of some alien acronym or phrase that I've been forced to digest as a financial writer -- like the 5-year-old being told to finish his lima beans before dessert. (Yuck.)
Fortunately, today isn't one of those days for me; I've already learned what I need to know about the R-squared ratio. You may not have. If so, take heart; you'll be fed no lima beans during this article -- unless, that is, you're already eating them as you read. And, if so, may I ask why?
But I digress. The R-squared ratio is a measure of value. Here's the technical definition, as explained by Investopedia: "... R-squared values range from 0 to 100. An R-squared of 100 means that all movements of a security are completely explained by movements in the index."
Translation: R-squared, expressed as a percentage, reveals how much of a fund's performance is attributable to stock-picking brilliance. The lower the percentage, the better the stock picker.
How it works
But not always. Here's the problem: R-squared, as useful as it may be, isn't a comprehensive measure. Some superior funds have very high R-squared ratios but outperform the indexes they're measured against.
Take T. Rowe Price Real Estate (FUND: TRREX ) , which is a fund of Real Estate Investment Trusts (REITs) that, according to Morningstar, has an R-squared ratio of 99. The movements of the Wilshire REIT index can explain all but 1% of its performance.
Yet that didn't stop Motley Fool GreenLight co-advisor Shannon Zimmerman, who also leads our Champion Funds service, from recommending the fund at the end of last summer. Since then, T. Rowe Price Real Estate has beaten its benchmark by more than 30%.
What gives? The fund's portfolio may look similar to that of the Wilshire REIT index, but because of the prowess of manager David Lee in allocating capital -- measured via other geeky stats known as alpha and beta -- T. Rowe Price Real Estate is more likely to place money with winners. Today, his biggest bets include Simon Property Group (NYSE: SPG ) , Equity Residential (NYSE: EQR ) , Archstone-Smith Trust (NYSE: ASN ) , and ProLogis Trust (NYSE: PLD ) .
Go under the hood
Still, you should know your fund's R-squared, if only to understand how the manager you've paid good money to invest with is adding value to your portfolio. Some may be like Lee, whose real worth comes from loading up on the winners he's already holding.
Others may be like Peter Lynch, who strayed wildly from the core holdings of the S&P 500 to produce 29% average annual gains for investors in Fidelity Magellan. Knowing this, some of Shannon's best funds feature an R-squared ratio well below 90.
Consider seeking the same for your own fund portfolio. How? Enter the ticker at Morningstar.com. Under "Risk Measures," you'll find the R-squared tally. Check the stats for both the standard index and the best fit index. If both measures are less than 90, you're betting on a manager who, like Lynch, is willing to zig as others zag.
Follow the money
To me, R-squared sounds like some sort of social disease that clears up after junior high. That's the nature of investing -- like lima beans, sometimes you have to gulp down nasty and obscure terms to keep your portfolio healthy and strong. But it's worth doing, if only to keep your savings safe from the occasional ice-cream binge of informed speculations that no investor can ever completely resist.
Interested in more moneymaking tips? Consider GreenLight. Shannon and co-advisor Dayana Yochim are offering 30 days of free access to the service right now. Click here to get started.
Interested in more mutual fund basics? Your digital chariot awaits:
- What is an expense ratio, anyway?
- Turn over the rock on portfolio turnover.
- Sometimes, five-star funds provide one-star returns.
- Stop your broker from sharing so much.
- Find out if you're overpaying to invest.
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Fool contributor Tim Beyers, ranked 2,063 out of more than 18,000 investors in Motley Fool CAPS, didn't own shares in any of the companies mentioned in this article at the time of publication. Get a peek at everything he's invested in by checking Tim's Fool profile. T. Rowe Price Real Estate is a Champion Funds pick. The Motley Fool's disclosure policy is always hip, never square.