The Coefficient of Determination

It is important to consider the coefficient of determination (R2) when evaluating a fund’s alpha or beta. The R2 measures how well the regression line actually fits the data. A high R2 value means that the regression line closely fits the data, as in the example in Figure 23(R2 = 0.9373). However, if R2 is low, the regression line does not fit the data, and any calculations based on regression line analysis, including alpha and beta, become less meaningful as the R2 value drops.

As Figure 24 illustrates, the returns have little relation to the regression line, and R2 is essentially 0. Drawing conclusions about a fund’s alpha or beta based on this particular regression analysis would yield no meaningful results.

Figure 24: Investment's Alpha and Beta - Take II

Investors who are required to select and monitor investment managers should develop a basic understanding of investment statistics. Quantitative tools can provide you with good insight that you can use in your qualitative interviews with managers and when monitoring your investments.