Treynor Ratio

The reward-to-volatility ratio, also called the Treynor ratio, is a metric used to know in a portfolio, how much excess return each unit of risk produces.

Above returns are what is gained in excess by an investment over and above what is obtainable from a risk-free investment. Despite the absence of any actual risk-free investments, Treynor ratios use treasury bills as examples of risk-free returns.

The Treynor ratio’s primary risk indicator is the systematic risk measured using the beta of a portfolio. Beta is an indication of how much a portfolio’s return rate would change relative to the overall market’s return rate.

Jack Treynor is an economist from the US who developed the Treynor ratio and designed the Capital Asset Pricing Model alongside others.

Understanding Treynor Ratio

The Treynor ratio calculates the risk-adjusted return achieved from an asset for each unit of systematic risk borne. The ratio, also known as reward/volatility, is its other name. Its beta shows how much systemic risk is associated with any given asset.

Nevertheless, the return adjusted for risk is the extra earnings an investor gets for taking a risk above the risk-free rate. Even though technically, there is no such thing as a riskless investment, the return rate given by Treasury Bills (T-bills) is generally treated as the free risk rate when calculating the Treynor ratio.

Components of Treynor Ratio

To understand how important the Treynor Ratio is when assessing investment performance, one must be aware of what constitutes it. Three elements are involved in computing this metric: portfolio return, risk-free rate, and portfolio beta.

Portfolio returns

A return on investment is the total gain that an investment portfolio makes over a chosen period. It consists of dividend payments, capital gains, and interest received, among others, which may result in fractions or even decimals when divided by the amount initially invested.

Risk-free rate

The risk-free rate is the return of a theoretically risk-free investment like a government bond. It is being used as a benchmark to measure the performance of riskier investments.

Portfolio beta

A stock is sensitive to market movements when its beta is high. At the same time, a stock can be inconsistent or volatile, which can be achieved through low beta values, which characterize it as being less susceptible to such influences.

Calculations of Treynor Ratio

The formula below shows that the ratio concerns both the portfolio’s return and systematic risk. Mathematically speaking, the formula indicates the amount of excess return over the risk-free rate for every unit of systematic risk. The Return/Risk Ratio is like the Sharpe Ratio.

The Treynor Ratio is one way to quantify a portfolio’s performance relative to other investments, and it is included within the CAPM.

Examples of Treynor Ratio

Assume you are contrasting two portfolios; the first is an Equity Portfolio, while the other one is a Fixed Income Portfolio. You have done thorough research on each of them, but you are uncertain about which one is a more profitable investment. The only way to make a sound judgement about a suitable investment is to apply the Treynor ratio.

The total return for the Equity Portfolio is 7%, and that of the Fixed-Income Portfolio is 5%. The risk-free rate is assumed to be the return realized on U.S. Treasury Bills, which stands at 2%. We have, therefore, taken up the Beta of 1.25 for the Equity Portfolio and 0.7 for the Fixed-Income Portfolio. Thus, the Treynor Ratio for both portfolios can be computed from the data given.

T(E)= 7%-2%/1.25= 0.049

T(F)= 5%-2%/0.7= 0.043

Based on the results shown above, the Equity Portfolio’s Treynor Ratio is only slightly higher. This makes it a better investment portfolio. Higher ratios suggest a better risk-return situation. Remember that these numbers come from historical data, which may differ from future ones.

Don’t rely on a single ratio for your investment decisions if you are a financial analyst. When making a final decision, you should also consider other financial metrics.

Frequently Asked Questions

What is systematic risk, and why is it important in the Treynor Ratio?

The overall market or economic system has a type of risk that affects everything invested in it to a varying extent. This risk is commonly referred to as systematic risk.

What are the limitations of the Treynor Ratio?

Even though it is helpful, the Treynor Ratio has shortcomings and is based on assumptions.

The Treynor Ratio, which only considers systematic risk and assumes that unsystematic risk has been eliminated through diversification, may not be true for all portfolios, particularly those with high concentration.

The ratio does not guarantee a risk-free rate and constant beta forever, which can change in environments with dynamic markets.

It may not be appropriate to use the Treynor ratio when comparing various portfolios with dissimilar investment goals and risk profiles.

How can I use the Treynor Ratio in portfolio management?

The Treynor ratio is based on the beta. Therefore, it indicates to what extent a portfolio’s fluctuation is like that of an index, such as the Nifty 50 or Sensex.

Where can I find the necessary data to calculate the Treynor Ratio?

Three inputs are needed, including Portfolio Return (Rp), when calculating the Treynor ratio. Most investors use a backward-looking average to estimate portfolio return, especially over five (5) years.