Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom. 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. Take self-paced courses to master the fundamentals of finance and connect with like-minded individuals. Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise. Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs.
How is the Treynor Ratio calculated, and what does it measure?
B is the Greek letter beta and stands for—you’ve guessed it—the beta we’re calculating. Rp is the stock’s return with the p in the formula standing for the measured stock in general in this formula. Rb is the return of the entire market with the letter b being used as it indicates the benchmark.
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Thus, the Treynor ratio will consider the non-diversifiable element of risk and give the additional risk-adjusted performance. For the Treynor Index, the measure of market risk used is beta, which is a measure of overall market risk or systematic risk. Beta measures the tendency of a portfolio’s return to change in response to changes in return for the overall market. The higher the Treynor Index, the greater the excess return being generated by the portfolio per each unit of overall market risk.
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The Treynor ratio is mainly used to measure the amount of return you are getting by taking on an extra unit of systematic risk. It is vital to understand the importance of measuring your return against the systematic risk, which is represented by the portfolio’s beta, instead of the standard deviation, which is the total risk. The Treynor Ratio is a risk-adjusted performance measure that indicates how much return an investment earned per unit of risk taken.
What is the Treynor ratio and how do you calculate it?
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. In case of a well-diversified portfolio, the risk will be low, and the total risk will be similar https://www.broker-review.org/ to the market risk. Thus, the Treynor ratio and Sharpe ratio will yield similar results, i.e. they will rank funds in the same order. However, in case of a non-diversified portfolio, the market risk will be a better measure of risk.
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- Rather than measuring a portfolio’s return only against the rate of return for a risk-free investment, the Treynor ratio looks to examine how well a portfolio outperforms the equity market as a whole.
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J.B. Maverick is an active trader, commodity futures broker, and stock market analyst 17+ years of experience, in addition to 10+ years of experience as a finance writer and book editor. Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling. As seen in its formula, calculating the Treynor Ratio requires knowing the Rf, Rp, and β. Since they’re required for calculating the ratio, it might be necessary to calculate these first. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content.
Conceived by Bill Sharpe, this measure closely follows his work on the capital asset pricing model (CAPM) and, by extension, uses total risk to compare portfolios to the capital market line. The Traynor Index 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. The index is a performance metric that essentially expresses how many units of reward an investor is given for each unit of volatility they experience. Treynor ratio is a measure of investment return in excess of the risk-free rate earned per unit of systematic risk.
However, their differences emerge due to variations in portfolio diversification levels. 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. A higher Treynor Ratio is preferable, as it shows that the portfolio is a more suitable investment on a risk-adjusted basis.
It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. 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.
There is no plain right or wrong in trading and speculation, and thus you need to both understand and comprehend what you are measuring. From the table above, Fund C has the least volatile returns as indicated by the lowest beta value. In fact, it is less volatile than the market benchmark is normally given a beta value of 1.
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). The beta coefficient measures the degree of risk of a security/portfolio in relation to the market as a whole. The higher the beta, the more volatile the security or the portfolio and vice versa. In the above case, lexatrade review Fund A provides better risk-adjusted returns than Fund B. Although Fund B seems to be a better choice due to its high returns, but higher returns are due to the higher risk taken by the fund. Therefore, while comparing two funds, it is ideal to choose a fund with a higher Treynor ratio as it is better at compensating for the risk-taking in comparison to the other fund with a lower Treynor ratio.
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. The Sharpe ratio is another return and risk ratio, and it seeks to understand how well an asset performed compared to a risk-free investment.
The CAPM is a model that determines an asset’s theoretically suitable minimum rate of return, helping investors make decisions regarding the addition of assets to a well-diversified portfolio. Essentially, a Treynor ratio reveals how well each unit of risk that a collection of securities, mutual funds, or ETFs assumes pays off. Thus, it isolates the risk factor and provides investors with a better understanding of the gains they can earn by undertaking the same. For example, if a standard stock market index shows a 10% rate of return—that constitutes beta. An investment portfolio showing a 13% rate of return is then, by the Treynor ratio, only given credit for the extra 3% return that it generated over and above the market’s overall performance. The Treynor ratio can be viewed as determining whether your investment portfolio is significantly outperforming the market’s average gains.
But it turned out to offer the best return per unit risk taken as shown by the Treynor Ratio. From the perspective of an investor, the insights derived from comparing the risk-adjusted fund returns contributes toward the selection of which funds to allocate their capital to. The Treynor ratio captures the difference between a portfolio’s total return and the risk-free rate, which is subsequently adjusted for the amount of risk undertaken on a per-unit basis. 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. This can be useful to know, because it can denote whether you have outperformed against the market. Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.
This means that you would go for one of the exotic low-risk investments in the equation only if you were trying to measure something very specific. There is a bit of a consensus—though far from unanimous—that you should try and compare like with like when figuring out the Treynor ratio. 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. 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.
