There’s a simple trick for advisors to figure out whether an actively managed mutual fund tracks its benchmark index too closely. Ever hear of R-squared?
R-squared, a measure that shows how much a fund moves in sync with an index, is a quick way for an advisor to compare an actively managed fund with an exchange-traded fund that makes no secret of index tracking. Knowing a fund’s R-squared number can help advisors determine whether the higher cost of an actively managed fund versus an ETF is worth the extra investment dollars.
For example, the S&P 500 index has an R-squared of 1.00 because its movements rise and fall in sync with the S&P 500 100% of the time. This suggests that an actively managed large-cap equity mutual fund whose R-squared approaches 1.00 is unlikely to be a good value, considering how much more cheaply an advisor can purchase similar shares in an ETF.
“Active managers can become too index fund-like, and therefore you’re paying fees for a closet indexer,” said Howard Present, president and chief executive of F-Squared Investments, Newton, Mass., which saw more than $4 billion in net inflows for 2011. “It’s safe to say no one has ever accused us of being a closet indexer because we have the ability to change the profile of the portfolio a lot, which we do. Certainly, in 2008, when we were 50% in cash and the only two active sectors we had were Consumer Staples and Utilities, it didn’t look like the S&P 500.”
What Your Peers Are Reading
F-Squared serves as investment manager for the Virtus Premium AlphaSector Fund (VAPAX), launched in 2011, using Select Sector SPDR ETFs as the basis of a strategy that invests in long-only U.S. equities and short-term Treasuries. VAPAX has a relatively low R-squared of 0.696. In comparison, the storied Fidelity Magellan (FMAGX) has an R-squared of about 0.91.
Beating or Mirroring the Benchmark?
Many data providers, including Morningstar, Bloomberg and Yahoo! Finance, list a fund’s R-squared in their risk metrics. For example, Yahoo! Finance’s risk profile of the SPDR S&P 500 (SPY) ETF shows an R-squared of 1.00 on the fund’s modern portfolio theory statistics page.
In an April 9 note, S&P Capital IQ noted that all funds use a benchmark index to track their relative performance, and the fund manager’s compensation often depends on the fund beating its benchmark. But active fund managers risk taking this concept too far by attempting to mirror its index, S&P Capital IQ warns.