Treynor Ratio What Is It, Formula, Calculations, Vs Sharpe Ratio

In addition, some might take issue with utilizing beta as a measure of risk. Several accomplished investors say that the beta and negative Treynor ratio can’t give  a clear picture of the involved risk. For many years, Warren Buffett and Charlie Munger have argued that the volatility of an investment isn’t the true measure of risk.

How to Combine Treynor Ratio with Other Metrics

Conversely, a low or falling Treynor Ratio may signal the need to adjust the portfolio by diversifying or reducing risk exposure. This could indicate that the portfolio is underperforming or that it is exposed to unnecessary risk without adequate returns. Suppose an investment firm’s portfolio has averaged a return of 8.0% over the trailing five years.

• 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.
• Regular assessment can help investors recognize trends, such as a decreasing Treynor Ratio, which might indicate increasing risk or diminishing returns.
• That gives you a fair way to see which one performs better for the same level of market risk.
• So when considering the market, the average comparison of beta values cannot give a fair result.

Treynor Ratio – Definition, Formula, What It Shows

The first portfolio is an equity portfolio and the other is a fixed income portfolio. This typically indicates that the portfolio’s returns are less than the risk-free rate or that the portfolio is taking on too much market risk for generated returns. A negative ratio is often a sign of poor performance. Since it focuses on market risk, it encourages investors to evaluate how their portfolios respond to market changes. Conversely, a low Treynor Ratio suggests that the portfolio’s returns are not sufficient to compensate for the level of market risk it carries. A high Treynor Ratio indicates that a portfolio is providing a good return relative to its risk.

The metric got its name from Jack Treynor, who developed it and used it first. A higher number indicates a more suitable investment or is considered a good Treynor ratio. With bear markets, on the other hand, lower ratios might still be acceptable if they demonstrate risk-adjusted returns.

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So, despite Portfolio B’s higher return, Portfolio A has a higher Treynor Ratio, indicating better risk-adjusted performance. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Suzanne is a content marketer, writer, and fact-checker.

That helps you avoid blind spots in your analysis. It ignores company-level or sector-specific risk. You miss key details if your portfolio isn’t diversified. The ratio says nothing about return volatility.

It can offer a clearer view of risk-adjusted performance for portfolios that track broader markets. A high Treynor ratio figure suggests that the portfolio is delivering strong returns for its level of risk, while a lower ratio may indicate underperformance relative to market volatility. Note that this metric specifically isolates market-related volatility while ignoring diversifiable risk, making it particularly useful for portfolios that are already well-diversified. You now understand what the Treynor Ratio measures.

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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.

Pair it with Sharpe or Sortino to get a full view. Add Jensen’s Alpha if you want to test performance against expectations. A stock or portfolio that has a beta of greater than 1 is riskier than a security or portfolio that is less than one. This again is a measure of systematic risk and it is risk at a macro level that cannot be diversified away by the portfolio manager. So, the beta is essentially a measure of unavoidable risk. It means you’re getting more return per unit of market risk, which indicates efficient investment management.

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On the other hand, if the Treynor Ratio is strong, it indicates efficient management, but regular monitoring is still important to maintain that balance. As mentioned earlier, the risk-free rate represents the return received on default-free securities, i.e. government bonds. Now that we have an understanding of a good and negative Treynor ratio and the outline of the concept, let us apply this theoretical knowledge into practical situations through the examples below.

Although there is no true risk-free investment, treasury bills are often used to represent the risk-free return in the Treynor ratio. If you are trying to evaluate fund manager skill? Changes in the risk-free rate affect the outcome. A shift in interest rates can move your Treynor score even when your portfolio stays the same. You can’t say what number counts as great across every asset.

• The Treynor Ratio in mutual funds is a powerful tool for evaluating fund performance.
• It shows how much excess return you get for every unit of market risk.
• 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.
• A ratio above 0.5 often signals strong performance.

By relating excess returns to market risk, it offers a clear lens for assessing whether a portfolio’s performance justifies its exposure. It looks at how your portfolio moves with the market. It covers both market risk and asset-specific risk. It uses standard deviation to measure how much your returns move up and down. You should use the Treynor Ratio only when your portfolio is well-diversified. It works best when unsystematic risk is already removed.

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.

This calculation is particularly useful for comparing portfolios with similar betas. The primary difference is the risk measure used. The Treynor ratio uses systematic risk (beta) in its denominator, while the Sharpe ratio uses total risk (standard deviation), making Treynor better for diversified portfolios. Some portfolio managers and analysts prefer the Treynor ratio over the Sharpe ratio, when they are looking at diversified portfolios. This is because in such portfolios only systematic risk is remaining as all other risks are diversified away. This systematic risk always persists, because of volatile behavior of financial markets.

It must be noted here that the direct and linear relationship between higher beta and higher long-term returns might not be as robust as it is believed to be. Academics and investors will invariably argue about the most effective strategies for activity risk for years to come. In truth, there may be no measure to be regarded as the perfect measure of risk. 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.

In other words, for every unit of market risk taken, the portfolio is delivering a higher level of return. From the perspective of an investor, the insights derived from comparing the risk-adjusted fund returns contributes toward the Best stocks to day trade selection of which funds to allocate their capital to. Risk in the Treynor ratio refers to systematic risk as measured by a portfolio’s beta. Beta measures the tendency of a portfolio’s return to change in response to changes in return for the overall market.