April 15, 2004 — The R-squared statistic measures how closely a fund follows the market. When put to good use, it can help mutual fund investors learn if they’re getting more ‘bang for the buck’ from their actively managed funds.

Investors would do well to avoid active funds with an R-squared of 95% or higher, since they will be paying higher management fees for what is nearly an index fund, which has lower fees. But, on the other end, if a fund’s R-squared is below 75%, it may not behave consistently with its style category. Therefore, it is important to understand the fund manager’s style and how the portfolio is constructed. After that, investors should start by looking for funds with an R-squared between 75% and 95%.

Standard & Poor’s reviewed all three large-cap fund investment styles over the past three years. Overall, value funds with an R-squared of less than 95% beat those with an R-squared of 95% or higher, while also beating the S&P 500. However, the average growth fund trailed the S&P 500 regardless of its R-squared. The results for blend funds were mixed.

Index funds have an R-squared of 100%, the highest possible, since their performance is completely tied to the performance of their underlying benchmark index. In contrast, actively managed funds have an R-squared of less than 100% because they don’t stick just to the S&P 500 or their benchmark index, and, therefore, the performance of the index does not fully explain the fund’s performance. The more a fund’s composition deviates from the S&P 500, the lower its R-squared, and the lower the correlation with the index.

While index funds are passive, and simply track the index’s return, resulting in lower expenses, actively managed funds spend more on research to beat their benchmark index. As a result, their expense ratios are higher. Yet, some actively managed funds have a high R-squared of 95% or more, meaning that they are closely mimicking the index. The question then becomes: Why pay higher expenses for a fund that is managed almost like an index fund, and whose performance is largely explained by the performance of the index? How much can a fund beat its benchmark by if it just mimics that benchmark?

In contrast, going against the crowd and deviating from the index, which will result in a lower R-squared, should, in theory, enable a fund to beat its benchmark. But when deviating from the index, a portfolio manager must pick the right stocks. Indeed, some active funds have a very low R-squared, but have still badly underperformed the S&P 500. Therefore, R-squared should be used with other measures of fund performance.

After breaking down the universe of large-cap funds into growth, value, and blend offerings, we sorted them by R-squared within each investment style. We used three groupings of R-squared: 74% and lower; 75% to 94%; and 95% and higher. Table 1, below, provides the average three-year returns, the percentage of funds in the category that beat the S&P 500, and the average expense ratio for each grouping. Results cover the three-year period through March 31, 2004.

Only the value category saw funds with an R-squared of less than 95% outperform the S&P 500, not surprising given the dominance of value stocks over the past three years, when they easily outperformed the S&P 500. However, while a lower R-squared resulted in better returns in value funds, it should again be noted that funds with an R-squared of 74% or less may not behave consistently with the corresponding style category, in this case large-cap value. The same holds for the large-cap blend category, where the 74% and under grouping was the only one to beat the S&P 500. Another concern here is that the outperformance came at a price, with the average expense ratio jumping to nearly 2%.

Among growth funds, all three R-squared groups trailed the S&P 500, which would be expected, given that growth stocks, overall, badly underperformed both value stocks and the S&P 500. It is interesting to note that while the average return for funds in the 74% and under category trailed the S&P 500, 37 out of 71 still managed to beat the index. Many that lagged the index did so quite badly, bringing the average down. One third of the funds in this category posted declines ranging from -5% to as low as -17%, compared to a 0.6% gain for the index.

To take the results a step further, we screened for the best performing funds in the growth, value, and blend categories, using several criteria. We first looked for funds with the highest one-year returns. However, many funds with low R-squared statistics that soared during the one-year period badly underperformed the S&P 500 in the three-year and five-year periods. Also, some are young funds that have been around less than five years, but badly lagged the S&P 500 in the three-year period as well. Therefore, in addition to screening for the top one-year performers, we screened for funds that also beat the S&P 500 in both the three-year and five-year periods, which covers not only the past year’s stellar gains, but also the recent bear market.

Next, we looked for funds with relatively low expenses. To break from the herd and build a portfolio with a lower R-squared that can beat the S&P 500, more must be spent on research. As a result, a lower R-squared is often accompanied by a higher expense ratio, sometimes up to 2% or even 3%. Since investors should balance higher returns against higher expenses, we also screened for the top performing funds with expenses of 1.25% or less. We then included the R-squared statistic to check the ‘bang for the buck’ on these funds. The resulting list, which includes Standard & Poor’s Star rankings, is below in Table 2.

Table 1 Large-Cap Fund Styles for the Period Ending March 31, 2004
Funds With

Three-Year

R-Square of

74% or Less

Funds With

Three-Years

R-Square of

75% to 94%

Funds With

Three-Years

R-Square of

95% or More

S&P 500
Average Three-Year Returns -0.66% -3.72% -2.17% +0.63%
Growth Funds Percentage That Beat the S&P 500 52.11% 11.96% 10.70% N/A
Average Expense Ratio 2.11% 1.60% 1.38% N/A
Average Three-Year Returns +1.34% +2.50% +0.50% +0.63%
Value Funds Percentage That Beat the S&P 500 56.00% 75.52% 50.65% N/A
Average Expense Ratio 1.40% 1.45% 1.34% N/A
Average Three-Year Returns 2.31% -0.11% -0.75% +0.63%
Blend Funds Percentage That Beat the S&P 500 78.57% 41.46% 27.59% N/A
Average Expense Ratio 1.98% 1.49% 1.36 N/A
Table 2 Top Funds Ranked by One-Year Returns Through March 31, 2004
One-Year Returns Three-Year Returns Five-Year

Returns

Expense Ratio (%) Three-Year

R-Squared (%)

Growth Funds/S&P Star Rank
Wells Fargo Funds: WealthBuilder Growth (WBGAX) — 4 Stars +50.06% +2.35% -0.42% 1.25% 0.9%
Chesapeake Core Growth Fund (CHCGX) — 5 Stars +49.49% +2.93% +8.3% 1.23% 0.9%
AFBA Five Star USA Global/Institutional (AFGLX) — 5 Stars +48.53% +2.7% +6.09% 1.08% 0.87%
Buffalo USA Global Fund (BUFGX) — 5 Stars +47.11% +3.14% +7.18% 1.04% 0.87%
Vanguard PRIMECAP (VPMCX) — 5 Stars +46.12% +2.06% +5.7% 0.51% 0.9%
Value Funds/S&P Star Rank
PIMCO Funds: PEA Value Fund/A (PDLAX) — 5 Stars +64.7% +10.17% +13.89% 1.1% 0.87%
Excelsior Value and Restructuring Fund (UMBIX) — 5 Stars +60.06% +7.52% +10.3% 0.99% 0.89%
AXP Invest Series: Dvsfd Equity Income Fund/A (INDZX) — 5 Stars +55.42% +7.24% +5.23% 1.04% 0.85%
Matrix Advisors Value Fund (MAVFX) — 5 Stars +53.27% +9.27% +12.66% 0.99% 0.88%
Smith Barney Fundamental Value/A (SHFVX) — 3 Stars +51.36% +2.04% +7.0% 1.15% 0.91%
Blend Funds/S&P Star Rank
Schwab MarketTrack All Equity Portfolio (SWEGX) — 4 Stars +45.45% +2.63% +1.41% 0.5% 0.94%
Thompson Plumb Growth Fund (THPGX) — 5 Stars +44.14% +8.88% +11.4% 1.11% 0.87%
Victory Funds: Diversified Stock Fund/A (SRVEX) — 4 Stars +42.12% +3.03% +3.98% 1.16% 0.94%
Morgan Stanley FOF: Domestic/A (DOFAX) — 3 Stars +40.69% +0.65% +1.95% 0.67% 0.89%
Brandywine Blue Fund (BLUEX) — 3 Stars +40.31% +1.63% +7.36% 1.14% 0.58%
S&P 500 +35.11% +0.63% -1.2% N/A N/A

Source: Standard & Poor’s. Total returns include reinvested dividends. Data as of 3/31/04.