If adding a new fund to the portfolio reduces its Treynor Ratio, it increases the risk involved without adding anything to the returns. Although the amount returned by the stocks was the same, the Treynor ratio shows that the stock with 1.3 beta is a low-risk option. Beta is an indicator of risk, as it determines the movement of a stock relative to an index.
If the portfolio manager (or portfolio) is evaluated on performance alone, manager C seems to have yielded the best results (a 15% return). However, when considering the risks that each manager took to attain their respective returns, Manager B demonstrated a better outcome. In this case, all three managers performed better than the aggregate market. The numerator identifies excess returns (also called risk premium), and the denominator corresponds to the portfolio’s sensitivity to the overall market’s movements (also called the portfolio’s risk). The Treynor, Sharpe, and Jensen ratios combine risk and return performance into a single value to measure portfolio performance.
With non-diversified portfolios, market risk is a better measure of risk. Treynor ratio will consider the non-diversifiable element of risk and yield additional risk-adjusted performance metrics. The Treynor Ratio calculates the excess return earned per unit of risk taken by a portfolio. It measures the risk-adjusted return based on the portfolio’s beta, highlighting returns earned in excess of the risk-free rate at a given level of market risk. It is a metric widely used in finance for calculations based on returns earned by a firm. Also known as the reward-to-volatility ratio, the Treynor ratio is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio.
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- The Treynor Ratio is a widely used performance measure that evaluates the risk-adjusted return of an investment portfolio relative to its systematic risk.
- It does this by substituting beta for standard deviation in the Sharpe ratio equation, with beta defined as the rate of return due to overall market performance.
- Risk in the Treynor ratio refers to systematic risk as measured by a portfolio’s beta.
Also, keep in mind the limitations of the ratio and compare mutual funds on other parameters, including the Treynor ratio, to make the right choice when investing. The Treynor ratio is a powerful tool that investors use to evaluate the performance of mutual funds. This ratio was first introduced by Jack Treynor in 1965 and has since become an industry standard for measuring the excess return per unit of market risk. Therefore, the Sharpe ratio is more appropriate for well-diversified portfolios because it more accurately takes into account the risks of the portfolio.
Beta as a Risk Measure
Investors can compare different funds to determine which would be ideal for their risk appetite as well as the one that provides reasonable returns at a particular level of risk. That’s why the Treynor ratio in mutual fund and ETF analysis is widely prevalent. 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. Similar to the previous performance measures discussed, the Jensen measure is calculated using the CAPM. Named after its creator, Michael C. Jensen, the Jensen ratio calculates the excess return that a portfolio generates over its expected return.
For instance, it would not be appropriate to use the Dow 30 Index to measure the beta of a mutual fund whose portfolio consists of small-cap companies. Investments that can produce higher returns with less risk or the same amount of risk as other investments are generally considered more attractive. Developed by American economist Jack Treynor, the Treynor Ratio is a way to measure how well a portfolio rewarded investors for the amount of risk it took on, over a certain time period. The fund’s beta would likely be understated relative to this benchmark since large-cap stocks tend to be less volatile in general than small caps. Instead, the beta should be measured against an index more representative of the large-cap universe, such as the Russell 1000 index.
The Treynor ratio is a financial metric used to evaluate a portfolio’s return relative to the return of a benchmark – like a leading index. You can use the Treynor Ratio to compare the return of your stock portfolio or a stock-based automated forex trading mutual fund to that of the equity market benchmark. 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.
Treynor Ratio: Evaluating Mutual Funds
You can use the Treynor’s ratio to compare between various mutual fund schemes and then shortlist suitable ones for investment. A high Treynor’s ratio is a favourable indicator as it shows that for each unit of risk that you undertake, you would earn a higher unit of return. Treynor ratio gives importance to how the portfolios behaved in the past. Let us take the example of a mutual fund portfolio to illustrate the Treynor ratio concept. During the last year, the portfolio generated a rate of 6.6%, while the government treasury bills generated a return of 3.0% during the same period. First, calculate the Treynor ratio of the portfolio if its systematic risk is 0.20.
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. An alternative method of ranking portfolio management is Jensen’s alpha, which quantifies https://bigbostrade.com/ the added return as the excess return above the security market line in the capital asset pricing model. As these two methods both determine rankings based on systematic risk alone, they will rank portfolios identically. If a portfolio has a negative beta, however, the ratio result is not meaningful. A higher ratio result is more desirable and means that a given portfolio is likely a more suitable investment.
The beta coefficient is the volatility measure of a stock portfolio to the market itself. 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.
While Treynor Ratio analyses and identifies investments that perform well among a group, it is effective only when it is a part of a broad portfolio. When the portfolios being compared have similar systematic risks but also a total variable risk, Treynor Ratio doesn’t offer the right picture. Unlike the Sharpe ratio, which uses the total risk as the denominator, the Treynor ratio uses the systematic risk. When we compare the Treynor ratio vs. Sharpe ratio, the former is usually considered to be the fairer variant. This is because, according to the efficient market theory, investors will only be compensated by taking on more systematic risk. You can check out our Sharpe ratio calculator to understand more on this topic.
Measuring a Portfolio’s Performance
A Treynor ratio of 3 does not necessarily mean it is 3 times better than a Treynor ratio of 1. However, there are a few limitations that you should keep in mind when using the metric. Its reliability is hence heavily dependent on the accuracy of the historical data. Although we can rank the Treynor ratios, as the higher Treynor ratios are generally better, we cannot say that a Treynor ratio of 5 is 2 times better than a Treynor ratio of 2.5.
At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. 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. Next, let’s look at some examples to understand how to calculate the Treynor ratio.
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 and Sharpe ratio have many characteristics in common since they both measure risk-adjusted return for portfolio.