Treynor Ratio – What Is Meaning, Formula and Calculation

Every investment you make must be based on calculations, especially ratio analysis. Successful investment strategies are created by carefully considering and analysing various metrics. Treynor Ratio is one such metric you should consider.

Understanding and using the Treynor Ratio can help you make informed investment choices. It allows you to weigh and compare the risk of your investments and helps you find the best investments at a certain level of market risk.

What is the Treynor Ratio?

The Treynor Ratio or reward-to-volatility ratio is a performance metric that calculates the returns of an investment in relation to its systemic risk. It helps you assess how well you are being compensated for taking every unit of additional risk you take on. Additional risk is the risk of an investment beyond the risk of a risk-free investment.

How the Treynor Ratio Works?

The Treynor Ratio evaluates a portfolio’s performance by measuring how much extra return it generates for each unit of market risk (beta). To calculate it, subtract the risk-free rate from the portfolio’s return and divide the result by its beta.

A higher Treynor Ratio indicates that the portfolio delivers better returns for the level of risk taken. Investors rely on this ratio to compare portfolios or funds and identify those that offer strong risk-adjusted performance. This makes it a valuable tool for making well-informed investment decisions.

Treynor Ratio Formula

TR = (Return of the Portfolio – Risk-Free Rate of Return) / Beta value of the portfolio

Here's what these terms mean:

- The Return of the Portfolio is the total returns earned by your portfolio.

- Risk-Free Rate of Return is the return on an investment with zero risk; this is usually a government treasury bill or bond.

- The Beta value measures the portfolio's risk in relation to the market. A beta of 1 show that the portfolio's price moves with the market, greater than 1 indicates higher volatility than the market, and less than 1 indicates lower volatility.

Treynor Ratio in Mutual Fund Example and Calculation

Let's consider this. Suppose the risk-free return rate in the market is at 2%. This means that for an investment like a government treasury bill where the risk is considered to be zero, you get a 2% return rate.

Now, we have to choose between two mutual funds:

1. Fund A, with a return rate of 12% and a 1.2 Beta Value.

2. Fund B, with a return rate of 10% and a 0.8 Beta Value.

At an initial glance, fund A has a higher return rate. However, when you calculate the Treynor ratio for both funds, you get a different picture. Let's see how.

TR for Fund A: (12%-2%)/1.2 = 8.3%

TR for Fund B: (10% -2%)/ 0.8= 10%

Although Fund A has a higher raw return rate, Fund B has a higher Treynor Ratio. This means that Fund B would provide a higher return for every additional unit of systematic risk that you take on. So, Fund B gives you better risk-adjusted performance.

What is the Difference between Treynor Ratio and Sharpe Ratio?

The Treynor Ratio and Sharpe Ratio both measure risk-adjusted returns, but they focus on different types of risk.

The Treynor Ratio considers only systematic risk (market risk) and uses beta to assess how much return a portfolio generates for each unit of market risk. It works best for diversified portfolios where unsystematic risks are already minimised.

On the other hand, the Sharpe Ratio looks at total risk, which includes both systematic and unsystematic risks. It uses standard deviation to measure the volatility of returns. This makes it suitable for portfolios that may not be fully diversified.

In a nutshell, both metrics help investors understand performance relative to risk, but their application depends on the portfolio’s risk structure and the type of analysis needed.

Final Thoughts

When you use Treynor Ratio be mindful that the ratio assumes that unsystematic risk has been diversified away. Also, use them in conjunction with other metrics such as the Sharpe Ratio and Jensen's Alpha.

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FAQs

What is Treynor Ratio in mutual funds?

The Treynor Ratio measures a portfolio's risk-adjusted returns based on market risk (beta). It aids investors understand how much excess return the portfolio generates for each unit of systematic risk taken.

How to calculate Treynor Ratio?

You can calculate the Treynor Ratio using the formula:

Treynor Ratio = (Portfolio Returns – Risk-Free Rate) / Portfolio Beta

Is a higher Treynor Ratio good?

A higher Treynor Ratio indicates that a portfolio generates better returns relative to the risk taken. It signifies that the portfolio is efficiently managed and suitable for investment.

What happens if the Treynor Ratio is negative?

A negative Treynor Ratio means the portfolio has underperformed compared to a risk-free investment. Investors typically avoid relying on a negative Treynor Ratio as it becomes less meaningful for analysis.

What is a good Treynor Ratio?

A higher Treynor Ratio is generally considered good, as it reflects better risk-adjusted performance and helps in making informed investment decisions.