Using R-Squared To Find More Bang For The Buck

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.

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