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

This can be useful to know, because it can denote whether you have outperformed against the market. The Sharpe ratio divides the equation by a standard deviation of the portfolio, which is the biggest difference between the Sharpe ratio and the Treynor ratio. Standard deviations can help to determine the historical volatility of an asset. Beta on the other hand, is a measure of an asset’s volatility as it relates to the overall market. But, it’s worth pointing out that if the beta value of the portfolio is negative, the Treynor ratio will not give an accurate or meaningful value.

When comparing funds or portfolios, higher Treynor Ratios are usually preferred, but it’s important to consider the market environment and the specific investment strategy. Hence, if one were to invest in XYZ mutual fund, their compensation or reward for assuming one unit of risk would be Rs.9.23. However, such a portfolio has to assume some degree of systematic risk to achieve additional returns. 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.

On that note, here’s to leveraging your knowledge of this evaluation tool en route towards investing in strategic mutual funds for your portfolio. The formula has transformed into a crucial tool for investors to measure risk-adjusted excess return of mutual funds and whether the average returns are acceptable in comparison to the prevailing risks. To simplify it, it basically measures the excess/abnormal returns of any investment in comparison to its estimated returns. This makes it a great option for evaluating mutual funds and many other types of assets.

Sortino Ratio: Formula, Calculator, and Definition

• Sharpe ratio is a metric similar to the Treynor ratio used to analyze the performance of different portfolios, taking into account the risk involved.
• Understanding how to interpret the Treynor Ratio is crucial for applying its insights to investment strategies.
• Investments are likely to perform and behave differently in the future than they did in the past.

For many years, Warren Buffett and Charlie Munger have argued that the volatility of an investment isn’t the true measure of risk. They might argue that risk is the likelihood of a permanent, not temporary, loss of capital. A portfolio with a high number of alexander elder volatile stocks will have a beta value greater than 1. On the other hand, if an investment has only a few volatile stocks, the β value of that investment will be less than one, indicating a negative Treynor ratio. Treynor ratio calculation is done by considering the beta of an investment to be its risk.

The beta of the portfolio is a critical factor, and a negative beta renders the Treynor Ratio meaningless. Since the formula subtracts the risk-free rate from the portfolio return and then divides the result by the beta of the portfolio — we arrive at a Treynor ratio of 4.6%. 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. You can use the Treynor ratio to measure the degree of excess profit you have achieved for every unit of risk that you have assumed above the level of risk in the underlying market.

Fund Groups

The β value of any investment is the measure of the investment’s volatility in the current stock market position. The more the volatility of the stocks included in the portfolio, the more the β value of that investment will be. The Treynor Ratio and Sharpe Ratio both measure risk-adjusted returns but focus on different types of risk.

Comparing ETFs, managed funds, and portfolios

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In this detailed guide, we will explore the fundamentals of the Treynor Ratio, its calculation, and its implications for your investment strategy. The Treynor ratio can be used across assets like mutual funds, portfolio of stocks, ETFs, etc. The next step involves dividing the excess return by the portfolio’s beta. This standardizes the return relative to the risk taken, offering a clear metric for comparing portfolios with different risk profiles. The Treynor Ratio is especially useful in evaluating portfolios in volatile markets, as it normalizes performance based on systematic risk.

How To Calculate?

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, 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. In the realm of investment analysis, evaluating performance is essential for making informed decisions. The Treynor Ratio is a key metric that provides insights into how well an investment compensates investors for taking on systematic risk. By focusing on this specific type of risk, it offers a perspective often overlooked by other metrics.

Here we’ll take you through the Treynor ratio and show you how to calculate it. Further, it can be effectively used for analyzing multiple portfolios only if given that they are a subset of a larger portfolio. In cases where the portfolios have varying total risk and similar systematic risks, they will be ranked the same, making this ratio useless in the performance analysis of such portfolios. Now, let us consider the raw analysis of the performance of the investments. When we look at the return percentages, Investment C is supposed to perform best with a return of 22%, while Investment B must have been chosen to be the second-best.

• The Treynor ratio shares similarities with the Sharpe ratio, and both measure the risk and return of a portfolio.
• Remember, a thorough understanding of your investment’s risk and return profile is essential for achieving your financial goals.
• Investors and fund managers use them to compare portfolios, but choosing the right metric depends on the investment type.
• By regularly assessing the Treynor Ratio and other performance metrics, investors can identify areas for improvement and adjust their investment strategies accordingly.

For example, let’s say that your stock portfolio returned 21% in the past year and had a beta of 2.4, while the S&P 500 Index Fund returned 10% during the same period. The Treynor Ratio is a measure used to assess the risk-adjusted performance of an investment or a portfolio. It is named after Jack Treynor, an economist who developed the ratio in the 1960s.

This is similar to the Sharpe ratio, but it only applies to a portfolio’s downside risk. Some analysts find that the Sortino ratio is better at measuring risk-adjusted returns than the Sharpe ratio because it discounts upside volatility, which is what will generally lead to profits for investors. Although the Treynor ratio is considered a better method to analyze and find out the better-performing investment in a pepperstone forex group of investments, it does not work in several cases. The Treynor ratio does not consider any values or metrics calculated utilizing the management of portfolios or investments. Therefore, this makes the Treynor ratio just a ranking criterion with several drawbacks, making it useless in different scenarios.

Treynor’s Ratio – Formula, Example and Evaluation Of Funds Using Treynor’s Ratio

This figure implies that for every unit of risk undertaken, the investor earns an excess return of 7.5% over the risk-free rate. The Treynor Ratio is a pivotal metric for investors aiming to assess the performance of a portfolio relative to its systemic risk. Particularly in the context of SIP (Systematic Investment Plans), understanding and calculating the Treynor Ratio can aid investors in making more informed decisions. Moreover, when you compare the Sharpe ratio and Treynor ratio, the latter would give a better understanding of the risk-adjusted returns that you can earn from a mutual fund scheme. Furthermore, the Treynor Ratio does not account for unsystematic risk, which is the diversifiable risk unique to individual securities or industries. While it is useful for assessing diversified portfolios where unsystematic risk is minimized, it may not be suitable for less diversified investments.

The Treynor Ratio helps investors understand whether they are being adequately compensated for the amount of market risk they are taking. Beta denotes the degree of change in returns a fund exhibits in response to market volatility. If the beta value of a financial asset or portfolio is high, it is more volatile and vice versa. This excess return is over and above the gains of a risk-free investment, which is often considered to be Treasury bills.

These two metrics are almost the same in that they both assess a portfolio’s risk and return. Their difference is, that while the Treynor ratio determines volatility with a portfolio beta or systematic risk, the Sharpe ratio adjusts returns based on the portfolio’s standard deviation. For instance, if two mutual funds have a return of 10%, investors will naturally gravitate towards the less risky one. The Forex pairs Jensen’s Alpha measure is a way to work out whether the portfolio is getting the right return for its risk level, i.e. if the value is positive. Now that you’re equipped with the knowledge of the Treynor Ratio and its importance in assessing risk-adjusted returns, it’s time to put theory into practice.

Instead, the beta should be measured against an index more representative of the large-cap universe, such as the Russell 1000 index. The premise behind this ratio is that investors must be compensated for the risk inherent to the portfolio, because diversification will not remove it. Measures the excess return over the anticipated return or performance relative to a benchmark index. Investors should aim for a higher Treynor Ratio when comparing investment options, as it reflects a more favorable risk-adjusted performance.