Treynor Ratio Definition, Formula, What It Shows

The premise behind this ratio is that investors must be compensated for the risk inherent to the portfolio, because diversification will not remove it. These ratios are concerned with the risk and return performance of a portfolio and are a quotient of return divided by risk. The Treynor Ratio is named for Jack Treynor, an American economist known as one of the developers of the Capital Asset Pricing Model. To improve this, you can consider diversifying your investments to reduce risk, or shifting towards assets with higher potential returns.

You have more than one way to measure risk-adjusted return. Sortino Ratio and Jensen’s Alpha are two others. You use it when your portfolio is already diversified. It shows how much excess return you get for each unit of market exposure.

It indicates how much return an investment, such as a portfolio of stocks, a mutual fund, or exchange-traded fund, earned for the amount of risk the investment assumed. Even though Fund B earned a higher return, Fund A offers better risk-adjusted performance, as it provided more excess return per unit of market risk. The Treynor Ratio is designed to assess risk-adjusted performance, focusing exclusively on market-related (systematic) risk rather than total volatility. It calculates how much excess return an investment earns over the risk-free rate for each unit of market risk taken.

Like the Sharpe Ratio, it is a Return/Risk Ratio. Trading forex (foreign exchange) or CFDs (contracts for difference) on margin carries a high level of risk and may not be suitable for all investors. There is a possibility that you may sustain a loss equal to or greater than your entire investment. Therefore, you should not invest or risk money that you cannot afford to lose. The products are intended for retail, professional, and eligible counterparty clients.

A ratio above 0.5 is typically considered strong, while anything close to or below zero may indicate poor performance relative to the market risk. The Treynor Ratio is a performance metric used to evaluate the risk-adjusted returns of an investment portfolio. However, for seasoned investors, it is important to understand the risk-adjusted returns as well to know if the kind of risk they are taking is converted into appropriate returns. This is exactly where the analysis of a good Treynor ratio and Sharpe ratio comes into the picture.

Formula

The key difference between the Treynor Ratio and the Sharpe Ratio lies in the type of risk they consider. It’s particularly useful for comparing the performance of different mutual funds or managed portfolios where the focus is on how well managers compensate for market-related risks. Investors also use the Treynor ratio for comparing portfolios with similar beta values.

Interpretation of the Formula

The fund’s beta would likely be understated relative to this benchmark since large-cap stocks tend to be less volatile in general than small caps. Instead, the beta should be measured against an index more representative of the large-cap universe, such as the Russell 1000 index. The Treynor ratio shares similarities with the Sharpe ratio, and both measure the risk and return of a portfolio. Excess return in this sense refers to the return earned above the return that could have been earned in a risk-free investment.

Treynor Ratio vs. Sharpe Ratio: What is the Difference?

In reality, the investments or portfolios are ever-changing. We can’t analyze one with just past knowledge as the portfolios may behave differently in the future due to changes in market trends and other changes. The Treynor ratio, also known as the reward-to-volatility ratio, is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio. The result indicates how much return the portfolio generates for each unit of systematic risk. A higher Treynor Ratio suggests better risk-adjusted performance. Given below are two portfolios, and we use the Treynor Ratio to decide which portfolio is a better investment.

Ultimately, comparing the Treynor ratio of a portfolio to similar investments or benchmarks provides a more accurate gauge of performance. If a portfolio has a negative beta, however, the ratio result is not meaningful. A higher ratio result is more desirable and means that a given portfolio is likely a more suitable investment. This measure is valuable for investors who want to distinguish between managers who generate higher returns through skill rather than simply taking on higher market risk. The Treynor Ratio is a portfolio performance measure that adjusts for systematic risk. In contrast to the Sharpe Ratio, which adjusts return with the standard deviation of the portfolio, the Treynor Ratio uses the Portfolio Beta, which is a measure of systematic risk.

How to Adjust Your Portfolio Based on the Treynor Ratio

In the Treynor ratio formula, we don’t consider the entire risk. Instead of that, systematic risk is considered. The understanding of the formula shall give us a clear understanding of the concept and its related factors and shall help us identify a good Treynor ratio as well. If you want to build an investment portfolio, a financial advisor can help you analyze and manage investments.

Because of these constraints, the Treynor Ratio is best used alongside other performance metrics like the Sharpe Ratio and Jensen’s Alpha. It’s advisable to calculate the Treynor Ratio periodically, such as quarterly or annually, depending on how actively you manage your portfolio. Regular monitoring can help track performance changes and make necessary adjustments based on market conditions. While the Treynor Ratio is invaluable for assessing risk-adjusted returns, it’s crucial to acknowledge its limitations.

• This allows for an apples-to-apples comparison of how well each portfolio performs relative to its exposure to market movements.
• Given below are two portfolios, and we use the Treynor Ratio to decide which portfolio is a better investment.
• We can’t analyze one with just past knowledge as the portfolios may behave differently in the future due to changes in market trends and other changes.
• Want to get better at managing risk and return?
• The Treynor ratio is calculated by subtracting the risk-free rate such as a government bond yield from the portfolio’s return, then dividing this figure by the portfolio’s beta.

By comparing the Treynor Ratio of different mutual funds, investors can better identify those that are managed more efficiently relative to their market risk exposure. The Treynor Ratio is a measure of a portfolio’s excess return per unit of systematic risk, or the market volatility of the portfolio. Stocks with a higher beta value have more chances to rise and fall more easily than other stocks in the stock market with a relatively lower beta value. So when considering the market, the average comparison of beta values cannot give a fair result. Hence, comparing investments with this measure is not practical.

• The Treynor Ratio is named for Jack Treynor, an American economist known as one of the developers of the Capital Asset Pricing Model.
• This written/visual material is comprised of personal opinions and ideas and may not reflect those of the Company.
• It is also known as a reward-to-volatility ratio or the Treynor measure.
• You use the Treynor Ratio if you manage a benchmarked fund or a market-based strategy.
• The fact sheet has information about various types of risks.

Treynor Ratio: What It Is, What It Shows, Formula To Calculate It

A Treynor Ratio of 0.5 means the portfolio earns 0.5 units of excess return for each unit of market risk. For example, it could mean a 5% excess return for a beta of 1.0. Treynor gives you useful insight but only part of the picture. It also doesn’t show volatility or downside movements. You miss key factors if you stop your analysis there. You should use the Treynor Ratio with other tools.

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Mutual fund companies communicate the performances of their funds on a periodic basis. They communicate their performances through a document called the fact sheet. This analysis is also conducted by external companies to show investors the best funds to invest in, sector-wise. The higher the Treynor ratio of a portfolio, the better its performance. Therefore, when analyzing multiple portfolios, using the Treynor ratio formula as a metric will help us analyze them successfully and find the best among them.

The higher the Treynor ratio, the better the risk-adjusted return i.e. a higher return per unit of systematic risk and consequently a better performance of the portfolio manager. The Treynor ratio is most effective when evaluating a well-diversified portfolio that is primarily exposed to systematic risk. In these cases, unsystematic risks, like company-specific or sector-specific volatility, are assumed to be minimized or eliminated. The Treynor ratio helps investors assess how well the portfolio compensates for market risk alone, making it useful for portfolios driven by their beta, or sensitivity to broader market trends. It’s particularly useful for evaluating diversified portfolios, where unsystematic risk (specific to individual assets) has been minimized. By using beta as the measure of risk, the Treynor Ratio isolates performance that comes purely from exposure to market movements.

Treynor Ratio can be explained as a number that measures the excess returns the firm could have earned by some of its investments with no variable risks, assuming the current market risk. The Treynor ratio metric helps managers relate the returns earned in excess over the risk-free rate of return with the additional risk that has been taken. The Treynor ratio can offer valuable perspectives on risk-adjusted returns.

Because the raw return doesn’t tell the full story. But you can see a portfolio might earn more but also carry more risk. Treynor Ratio shows if you’re getting paid fairly for that risk. You’ll learn what the ratio means, how to calculate it, and when to use Biggest stock gainers of all time it.