Definition
The Treynor Ratio, named after economist Jack Treynor, is a performance metric for determining how well an investment has compensated its investor for each unit of market risk taken. It calculates the excess return per unit of risk associated with a portfolio, compared to a risk-free rate, normally the return on a U.S. Treasury Bond. A higher ratio indicates a more efficient investment, offering greater reward per unit of risk.
Key Takeaways
- The Treynor Ratio is a risk-adjusted measurement of return based on systematic risk. It is designed to aid investors in comparing the performance and return of different investments.
- The ratio is named after Jack L. Treynor, who developed the measure as a tool for comparing the risk-adjusted returns of diverse portfolios. It’s calculated by dividing the excess return of an investment by its beta, or its sensitivity to market movements.
- A higher Treynor Ratio indicates a more desirable investment. A positive ratio indicates that the investment has a good return for the level of risk taken, while a negative ratio indicates a poor return for the level of risk. However, it is only applicable for diversified portfolios as it does not consider the total risk.
Importance
The Treynor Ratio, also known as the reward-to-volatility ratio, is a crucial performance metric in finance as it helps investors identify the risk-adjusted returns of an investment portfolio or a security. It is calculated by dividing the excess earned returns of the portfolio over the risk-free rate by the portfolio’s beta.
This ratio equips investors with insight into how much return their investments have yield per unit of market risk taken. Therefore, a higher Treynor Ratio indicates a more desirable investment.
It lets investors compare diverse portfolios and determine the most rewarding investments relative to the risk involved, thereby aiding smarter decision-making in the investment process.
Explanation
The Treynor Ratio, also referred to as the reward-to-volatility ratio, serves as a critical gauge in the financial world to evaluate the returns earned in excess than that could have been earned on a riskless investment, per each unit of market risk. In essence, it characterizes the risk-adjusted performance of an investment portfolio or security, helping investors to determine the risk associated with every unit of return for a given portfolio.
Popularized by Jack Treynor, this financial metric has found profound significance in the arena of portfolio management and performance evaluation. The primary use of the Treynor Ratio is the assessment of an investment’s profitability vis-à-vis its inherent systematic risk (market risk). As such, this ratio allows investors or portfolio managers to make prudent decisions about the portfolio’s construction, aiding in the determination of whether the risk taken is worth the returns.
It provides a quantitative measure of the returns produced over and above that of a risk-free rate, adjusting for market risk. In a nutshell, a higher Treynor Ratio indicates a more desirable portfolio or investment – offering higher reward per unit of systematic risk.
Examples of Treynor Ratio
Mutual Funds: Let’s consider an investment in a mutual fund. The Treynor Ratio is used to evaluate the performance of the mutual fund taking into consideration the systematic risk involved. If the mutual fund has a high Treynor Ratio, it indicates that it has been able to provide higher returns for the level of risk undertaken, making it a desirable investment.
Portfolio Management: An investment manager managing a diversified portfolio can use the Treynor Ratio to gauge how well the portfolio is performing by comparing it to other portfolios or a market benchmark. For instance, if Portfolio A has a Treynor Ratio of
10 and Portfolio B has a Treynor Ratio of
07, this indicates that Portfolio A is generating more returns per unit of risk than Portfolio B.
Pension Funds:Pension fund managers also use the Treynor Ratio to evaluate the performance of their investment choices. If the fund managers are investing in risky assets, they would expect to see a high Treynor ratio which would indicate they are gaining sufficient return for the additional risk they are taking on. If not, it may be a signal to rethink the investment strategy.
FAQs for Treynor Ratio
What is the Treynor Ratio?
The Treynor Ratio, named after its developer, Jack Treynor, is a performance metric for investments. It measures the returns earned above that which could have been earned on a riskless investment per each unit of market risk.
How is the Treynor Ratio calculated?
The Treynor Ratio is calculated by subtracting the risk-free rate from the portfolio’s rate of return, and then dividing this by the portfolio’s beta.
What does a higher Treynor Ratio indicate?
A higher Treynor Ratio indicates a more desirable portfolio. It means that the investor is getting higher returns in relation to the risk taken.
What is the difference between the Treynor Ratio and the Sharpe Ratio?
The primary difference is that the Sharpe Ratio uses standard deviation as its measure of risk, while the Treynor Ratio uses beta, or volatility. Another significant difference is that the Sharpe Ratio considers total risk whereas Treynor Ratio considers only systematic risk.
Is the Treynor Ratio always reliable?
No, the Treynor Ratio isn’t always entirely reliable. The beta used in the ratio may not always offer a complete picture of a portfolio’s risk. Additionally, like many financial ratios, it is based on past performance which cannot guarantee future results.
Related Entrepreneurship Terms
- Portfolio Performance
- Risk Premium
- Systematic Risk
- Market Return
- Investment Analysis
