For instance, the standard deviation calculation shows the total risk involved in the fund, Beta is a measure of the market risk. 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. Investors also use the Treynor ratio for comparing portfolios with similar beta values.
How to Adjust Your Portfolio Based on the Treynor Ratio
Therefore, assessing the past returns clocked by the mutual fund in isolation would be inaccurate because they will not indicate the extent of risk you have been exposed to as an investor. The Treynor ratio and Sharpe ratio have many characteristics in common since they both measure risk-adjusted return for portfolio. The only difference between the two is how they measure risk related to the investment. While Treynor ratio uses Beta which is a portfolio return volatility relative to market’s (systematic risk), Sharpe ratio uses the actual portfolio return volatility (total risk). You should use the Treynor Ratio only when your portfolio is well-diversified. It works best when unsystematic risk is already removed.
- The β value can be measured, keeping the value of 1 as a benchmark.
- You decide to use the Treynor Ratio to help you select the best portfolio investment.
- To carry out the Treynor Ratio calculations, we also need the risk-free rate of the three investments.
- A high Treynor Ratio indicates that a portfolio is providing a good return relative to its risk.
- As a financial analyst, it is important to not rely on a single ratio for your investment decisions.
Given the insights derived from the Treynor Ratio, investors can strategically adjust their roboforex overview portfolios to enhance their risk-adjusted returns. Since the formula subtracts the risk-free rate from the portfolio return and then divides the result by the beta of the portfolio — we arrive at a Treynor ratio of 4.6%. The Treynor ratio is similar to the Sharpe ratio in many aspects because both metrics attempt to measure the risk-return trade-off in portfolio management. Sharpe ratio is a metric similar to the Treynor ratio used to analyze the performance of different portfolios, taking into account the risk involved.
Treynor Ratio Limitations
The Treynor Ratio is not just a one-time calculation but a metric that should be monitored over time to track an investment’s performance relative to market changes. For instance, a Treynor Ratio close to zero or negative means that the returns do not justify the risk, and the investment strategy might need reevaluation. While both the Treynor Ratio and Sharpe Ratio are used to measure risk-adjusted returns, there are key differences between them. In the Treynor ratio formula, we don’t consider the entire risk.
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. A portfolio can show a strong Treynor score but still move wildly in the short term.
Treynor Ratio Calculation Example
You get the best results when you use them together. You have more than one way to measure risk-adjusted return. Sortino Ratio and Jensen’s Alpha are two others. You use it when your portfolio is already diversified.
Treynor Ratio in Mutual Fund Analysis
It works well for portfolios that aim to protect capital. Jensen’s Alpha shows how much return you earn beyond what the CAPM predicts. A positive alpha means your portfolio beats expectations.
- For instance, the standard deviation calculation shows the total risk involved in the fund, Beta is a measure of the market risk.
- However, what qualifies as a good Treynor ratio can vary depending on market conditions and the investment strategy.
- Suppose you are comparing two portfolios, an Equity Portfolio and a Fixed Income Portfolio.
- While the risk-free rate is the rate of the return of a risk-free asset which is usually assumed to be the treasury bond of the same currency.
- The Treynor ratio, also known as the reward-to-volatility ratio, is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio.
- You should use the Treynor Ratio only when your portfolio is well-diversified.
Limitations of The Treynor Ratio
If the beta changes often or flips negative, your result becomes unreliable. You get a number that no longer reflects the actual risk. Past returns won’t always tell you what comes next. The Treynor Ratio and the Sharpe Ratio are both measures used to evaluate the performance of an investment portfolio, but they differ in how they account for risk.
How to Combine Treynor Ratio with Other Metrics
Get market insights, education, and platform updates from the Volity team. Get the latest insights & exclusive offers delivered straight to your inbox. 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.
As we have seen, investors must find mutual funds to help them meet their investment objectives at the required risk level. And they should realize that gauging the risk involved in a mutual fund scheme just based on the NAV of the fund reports might not be a holistic assessment. It is noteworthy that, in a fast-rising market, it’s not altogether tough to clock higher growth if the fund manager is willing to take up a higher risk. There have been many such occasions in the past, like the rallies of 1999 and early 2000, as well as many mid-cap stock rallies.
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. The Treynor ratio shares similarities with the Sharpe ratio, and both measure the risk and return of a portfolio. Excess return in this sense refers to the return earned above the return that could have been earned in a risk-free investment.
In particular, the Treynor ratio is used to perform comparative analysis among different funds to compare the historical track record of a specific portfolio manager (and investment fund). 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. The Treynor ratio, also known as the reward-to-volatility ratio, is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio. Beta (β) is a financial metric measuring the volatility of the asset or portfolio return compared to its benchmark.
Hence, comparing investments with this measure is not practical. So here comes the utility of the Treynor ratio because it helps compare investments or stocks with nothing common to get a clear performance analysis. A higher Treynor ratio suggests the portfolio is delivering more return per unit of market risk, while a lower ratio could indicate insufficient compensation for the risk taken. This calculation is particularly useful for comparing portfolios with similar betas.
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