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

Once the risk-free rate is subtracted from the expected or actual rate of return it would then be divided by the standard deviation. The Treynor Ratio is a risk-adjusted performance measure that indicates how much return an investment earned per unit of risk taken. It adjusts for systematic risk, offering insights into the efficiency of an investment on a risk-adjusted basis.

A portfolio with a higher beta has a bigger return potential, but it also has a bigger risk. So, beta is a measure of systemic risk, which is the risk in a portfolio that cannot be offset by diversification within the same market. The Treynor Ratio is a risk-adjusted performance metric that evaluates the return generated by an investment portfolio relative to its systematic risk. The Sharpe Ratio is a similar metric that evaluates the risk-adjusted return of an investment portfolio. However, unlike the Treynor Ratio, which focuses on systematic risk, the Sharpe Ratio considers the investment’s total risk, including both systematic and unsystematic risk. Understanding the components of the Treynor Ratio is crucial to appreciating its significance in evaluating investment performance.

The Treynor Ratio is calculated by dividing the portfolio’s excess return over the risk-free rate by the portfolio’s beta, which measures its sensitivity to market movements. The Treynor Ratio focuses solely on systematic risk and assumes that unsystematic risk has been eliminated through diversification. This can lead to misleading results when comparing non-diversified portfolios or portfolios with high levels of unsystematic risk. Portfolio managers can use the Treynor Ratio to assess the risk-adjusted return of their investment portfolios and make informed decisions about asset allocation and risk management strategies. The Treynor ratio is a performance indicator that measures the amount of return that a portfolio generates with every unit of risk.

Risk-Adjusted Performance Comparison

The Treynor Ratio, sometimes called the reward to volatility ratio, is a risk assessment formula that measures the volatility in the market to calculate the value of the excess return per unit risk taken in a portfolio. It is a metric widely used in finance for calculations based on returns earned by a firm. The Treynor Ratio is a portfolio performance measure that adjusts for systematic – “undiversifiable” – risk. In contrast to the Sharpe Ratio, which adjusts returns with the standard deviation of the portfolio’s returns, the Treynor Ratio is a measure of returns earned in excess of the risk-free return at a given level of market risk.

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Like the Sharpe ratio, the Treynor ratio (T) does not quantify the value added, if any, of active portfolio management. A ranking of portfolios based on the Treynor Ratio is only useful if the portfolios under consideration are sub-portfolios of a broader, fully diversified portfolio. If this is not the case, portfolios with identical systematic risk, but different total risk, will be rated the https://forexanalytics.info/ same. But the portfolio with a higher total risk is less diversified and therefore has a higher unsystematic risk which is not priced in the market. The difference between the two metrics is that the Treynor ratio utilizes beta, or market risk, to measure volatility instead of using total risk (standard deviation) like the Sharpe ratio.

This approach allows investors to identify the optimal combination of active and passive investments to maximize risk-adjusted return. These enhancements include the Modified Treynor Ratio, the Treynor-Black Model, and the incorporation of alternative risk measures. As mentioned earlier, the Treynor Ratio assumes that unsystematic risk has been eliminated through diversification. The Equity Portfolio’s total return is 7%, and the Fixed Income Portfolio’s total return is 5%. As a proxy for the risk-free rate, we use the return on U.S Treasury Bills – 2%. Assume that the Beta of the Equity Portfolio is 1.25, and the Fixed Income Portfolio’s Beta is 0.7.

Overemphasis on Systematic Risk

Keep in mind that Treynor Ratio values are based on past performance that may not be repeated in future performance. The main disadvantage of the Treynor ratio is that it is backward-looking and that it relies on using a specific benchmark to measure beta. Most investments, though, don’t necessarily perform the same way in the future that they did in the past. The Treynor Ratio is an ordinal number, meaning it provides a ranking of portfolios or investments based on their risk-adjusted performance but doesn’t convey the magnitude of the difference in performance. It tells you which portfolio is better than another but doesn’t indicate how much better. While the Treynor Ratio is a useful metric that can help you make informed investment decisions, there are some limitations to keep in mind.

1. Working with a wealth management professional who understands how to interpret and apply this metric can help investors make better-informed decisions and achieve their long-term financial goals.
2. Generally speaking, the higher the Treynor ratio, the better the investment’s performance.
3. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice.
4. A portfolio with a higher beta has a bigger return potential, but it also has a bigger risk.

From a purely mathematical perspective, the formula represents the amount of excess return from the risk-free rate per unit of systematic risk. This is represented by the numerator of the equation which is the portfolio return minus by risk-free rate. While the risk-free rate is the rate of the return of a risk-free asset which is usually assumed to be the treasury bond of the same currency.

The difference between Treynor Ratio and Sharpe Ratio

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Since the Treynor ratio is based on historical data, however, it’s important to note this does not necessarily indicate future performance, and one ratio should not be the only factor relied upon for investing decisions. Where the Sharpe ratio fails is that it is accentuated by investments that don’t have a normal distribution of returns like hedge funds. Many of them use dynamic trading strategies and options that can skew their returns. Developed around the same time as the Sharpe ratio, the Treynor ratio also seeks to evaluate the risk-adjusted return of an investment portfolio, but it measures the portfolio’s performance against a different benchmark.

You decide to use the Treynor Ratio to help you select the best portfolio investment. When comparing similar investments, the higher Treynor ratio is better, all else equal, but there is no definition of how much better it is than the other investments. The premise behind this ratio is that investors must be compensated for the risk inherent to the portfolio, because diversification will not remove it. Secondly, the Treynor Ratio assumes that the risk-free rate is constant over time, which is not necessarily the case. This means that you should use caution when interpreting the results of the Treynor Ratio and be aware of any changes to the risk-free rate.

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Firstly, the Treynor Ratio only looks at systematic risk, meaning that it doesn’t take into account unsystematic or idiosyncratic risk. This means that it’s not a perfect measure of risk-adjusted returns, and you should be aware of this when making investment decisions. A higher Treynor Ratio is preferable, as it shows that the portfolio is a more suitable investment on a risk-adjusted basis. Since beta is a measure of the systematic risk, which cannot be reduced by diversifying within the same market, the Treynor Ratio tries to show how well the investment compensates the investor for taking the risk. Of course, an investor deserves a return for taking a risk, and the Treynor Ratio can tell him/her how much return the investment has earned per unit risk. 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.

While it’s not a perfect measure and has its limitations, the Treynor Ratio is definitely a metric worth knowing and understanding. 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.