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. The Treynor ratio is similar to the Sharpe ratio in many aspects because both metrics attempt to measure the risk-return trade-off in portfolio management. What this means is that you don’t use it for a portfolio of securities from different asset classes as there would be no benchmark to compute the beta. Using the equity market benchmark to compute the beta for such a portfolio could lead to a beta value of zero or a negative beta value, both of which would render the Treynor Ratio meaningless. A negative Treynor ratio indicates that the investment has performed worse than a risk-free instrument. The Treynor ratio helps to make an investment decision based on the reward-to-risk ratio of a security.
The Treynor ratio is used extensively to measure the risk-adjusted return potential of investments. However, investors need to understand that there are also limitations to this approach. Ultimately, the Treynor ratio attempts to measure how successful an investment is in providing compensation to investors for taking on investment risk.
How to calculate the Treynor ratio? — Treynor ratio formula
Total risk is equivalent to the sum of the systematic risk and the unsystematic risk. As unsystematic risk is the risk that can be diversified away, according to the efficient market theory, investors should not expect to be compensated by taking on more unsystematic risk. That’s why the Treynor ratio is often considered to be theoretically more accurate. The Treynor Ratio is a portfolio performance measure that adjusts for systematic risk.
- But since the ratio is derived using historical data and past performance, it is an imperfect indicator of future performance (and should be evaluated alongside other relevant metrics).
- Investors need to assess metrics and check if they align with their goals.
- Beta establishes volatility by comparing an asset to an index, which might not always be useful.
- Most importantly, it tells us how much return you are getting per unit of systematic risk you are taking.
- 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.
In other words, It measures the excess rate of return generated by the investment for each unit of assumed systematic risk. Therefore, an investor desires a higher ratio value as it indicates a better return per unit of assumed risk. The Treynor Ratio calculates the excess return earned per unit of risk taken by a portfolio.
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The Treynor reward to volatility model, named after Jack L. Treynor, is a measurement of the returns earned in excess of that which could have been earned from a risk-free investment. Thus, Sharpe and Treynor Ratios will offer similar results, i.e. they will come up with the same order of funds. With non-diversified portfolios, market risk is a better measure of risk. Treynor ratio https://www.investorynews.com/ will consider the non-diversifiable element of risk and yield additional risk-adjusted performance metrics. Both the Treynor Ratio and Sharpe Ratio measure the performance of an investment per unit risk, but they do it differently. Another difference is that Treynor Ratio uses historical returns only, while the Sharpe ratio can use either expected returns or actual returns.
In particular, the Treynor ratio is used to perform comparative analysis among different funds to compare the historical track record of a specific portfolio manager (and investment fund). For instance, it would not be appropriate to use the Dow 30 Index to measure the beta of a mutual fund whose portfolio consists of small-cap companies. Suppose 60% of the portfolio is made of Stock A, whose beta is 1.7 and returns 10%. The remaining 40% is invested in Stock B, which has a beta of 2.1 and yields 17%.
One of the common uses of the Treynor Ratio is to compare the returns from different funds to know the one that earns more return compared to the amount of risk inherent in it. A fund may seem to be making more returns, but at the same time, the returns may be subject to significantly more volatility than the one that appears to be making a lower return. But you should note that the returns here are of the past, which may https://www.forex-world.net/ not indicate future performance. So, you shouldn’t rely on this one ratio alone for your investment decisions. Developed by American economist Jack Treynor, the Treynor Ratio is a way to measure how well a portfolio rewarded investors for the amount of risk it took on, over a certain time period. These ratios are concerned with the risk and return performance of a portfolio and are a quotient of return divided by risk.
In the stock market, the broad market index, such as the S&P 500, is given a beta of 1. A beta of more than 1 means that the asset or portfolio is more volatile than the market, while a beta of less than 1 but greater than zero indicates a less volatile asset. When the beta is zero, the asset is not correlated to the market, and when it is less than zero, https://www.currency-trading.org/ the asset is negatively correlated to the market. By measuring the excess returns of a portfolio per unit systemic risk taken, the Treynor Ratio is a measurement of efficiency, utilizing the relationship between risk and returns. The risk-free rate can be regarded as the amount one gets in a savings account or the rate offered on US treasury bills.
Since we now have an understanding of what the Treynor ratio is and its calculation, we can now talk about how to interpret what is a good Treynor ratio. Next, let’s look at some examples to understand how to calculate the Treynor ratio. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.
Uses of Treynor Ratio in Trading
It is a performance metric that measures the return a portfolio generates in excess of the risk-free rate and divides that by the systematic risk. As a measure of the risk-adjusted return of a financial portfolio, Treynor Ratio can be used to compare the performance of investments in different asset classes. Also known as the reward-to-volatility ratio, the Treynor ratio is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio.
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. From the formula below, you can see that the ratio is concerned with both the return of the portfolio and its systematic risk. From a purely mathematical perspective, the formula represents the amount of excess return from the risk-free rate per unit of systematic risk.
Usually, a mutual fund with a higher Treynor ratio is considered a better investment than one with a lower Treynor Ratio. In case the portfolio is well diversified, the risk will be low and the total risk will be similar to the market risk. In essence, the Treynor ratio is a risk-adjusted measurement of return based on systematic risk. 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.
If adding a new fund to the portfolio reduces its Treynor Ratio, it increases the risk involved without adding anything to the returns. Although the amount returned by the stocks was the same, the Treynor ratio shows that the stock with 1.3 beta is a low-risk option. Beta is an indicator of risk, as it determines the movement of a stock relative to an index. For instance, if the investment returns 9% in one year and the risk-free rate is 1% per annum, the excess rate will be 8%. 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.
Beta establishes volatility by comparing an asset to an index, which might not always be useful. This is because some assets may not have a relative index to compare with. Standard deviation, on the other hand, works well only with evenly distributed data. Investors can measure the performance of their portfolio and assess if the trading risk is worth it using the Treynor ratio. Treynor ratio falls under the category of performance metrics and is a critical tool for decision-making in investing.
When using the Treynor Ratio, keep in mind:
The Treynor Ratio is named for Jack Treynor, an American economist known as one of the developers of the Capital Asset Pricing Model. A higher Treynor Ratio is preferable, indicating better risk-adjusted performance. However, the magnitude of the difference between two ratios is not indicative of their relative strength. The beta of the portfolio is a critical factor, and a negative beta renders the Treynor Ratio meaningless. When you are looking at trading performance metrics, like the Treynor Ratio, please make sure you understand what you are measuring.
