Index Correlation (R²) measures how much of a fund's return movements can be explained by the movement of its benchmark index — ranging from 0 (no relationship) to 1 (perfect tracking).
Index Correlation is expressed as R² (R-squared) from a regression of fund returns against index returns. R² of 0.95 means 95% of the fund's return variation is explained by the benchmark's movements. The remaining 5% comes from the fund manager's active bets (stock selection, sector over/underweights). For index funds, R² should be > 0.99. For active funds, R² of 0.7–0.85 indicates meaningful active management. R² below 0.5 means the fund barely tracks its stated benchmark.
Index Correlation (R²) asks: 'How much does this fund move in lockstep with the market?' An index fund should have R² close to 1.0 — it should perfectly mirror the benchmark. An active fund with R² of 0.95 is 'closet indexing' — 95% of its movements are just the market. An active fund with R² of 0.75 has meaningful independence — 25% of its movements come from the manager's independent decisions. Combined with Active Share and Tracking Error, R² paints the full picture of how active the fund really is.
Regress monthly fund returns against benchmark returns over 36 months.
R² = coefficient of determination from the regression.
R² of 1.0: fund perfectly tracks benchmark (ideal for index funds).
R² of 0.95: fund moves 95% in sync with benchmark (high passive drift).
R² of 0.70: fund has meaningful independence from benchmark.