# What is the Treynor Ratio and How Do You Calculate It? IG International

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. But since the ratio is derived using ema indicator historical data and past performance, it is an imperfect indicator of future performance (and should be evaluated alongside other relevant metrics). Designed by economist Jack Treynor, who also created the capital asset pricing model (CAPM), the ratio is used by investors to make informed decisions regarding asset allocation and portfolio diversification.

- Excess return in this sense refers to the return earned above the return that could have been earned in a risk-free investment.
- The Sharpe Ratio is a similar metric that evaluates the risk-adjusted return of an investment portfolio.
- In essence, the Treynor ratio is a risk-adjusted measurement of return based on systematic risk.
- For example, assume Portfolio Manager A achieves a portfolio return of 8% in a given year, when the risk-free rate of return is 5%; the portfolio had a beta of 1.5.
- Treynor Ratio is used to compare different Mutual fund Schemes on risk-adjusted parameters.

You can find the Treynor Ratios of different mutual funds easily online in our StockEdge application or the web version. You should check the Treynor ratio of the fund when selecting the mutual fund before investing. The main difference between the Sharpe ratio and the Treynor ratio is that the Treynor Ratio uses the systematic risk (beta), while the Sharpe ratio uses the total risk or the standard deviation. The best performance indicator measures a portfolio’s returns against a benchmark and the risks.

These enhancements include the Modified Treynor Ratio, the Treynor-Black Model, and the incorporation of alternative risk measures. If interested, download the Navi app by clicking here, explore funds based on your goals and risk tolerance, and start investing in a few minutes in a 100% paperless manner. As a result, upside volatility is positive for an investor, and is excluded from the risk-adjusted return equation when using the Sotrino ratio. Suppose an investment firm’s portfolio has averaged a return of 8.0% over the trailing five years.

## Portfolio Beta

Where the Sharpe ratio fails is that it is accentuated by investments that don’t have a normal distribution of returns like hedge funds. Many of them use dynamic trading strategies and options that can skew their returns. A higher Treynor Ratio is preferable, indicating better risk-adjusted performance.

## What are the limitations of Treynor Ratio?

Sharpe Ratio is a metric, similar to the Treynor ratio, used to analyze the performance of different portfolios, taking into account the risk involved. The equation for calculating Treynor Ratio is similar to the method of Sharpe Ratio for assessing the risk and volatility in the market with just one exception. For example, one fund manager might make better investment decisions for long-term profitability, but another fund outperforms it in the short run because of market up and down swings. The Treynor calculation cancels out this market instability to show which fund manager is actually making better decisions and creating a fundamentally more profitable investment.

In this case, each portfolio’s beta is computed by comparing its returns to its market index, and the Treynor Ratio (which is the excess return per unit risk) of both portfolios can then be compared. It measures the excess returns a financial asset or a group of securities earns for every extra unit of risk assumed by the portfolio. It is also called the reward-to-volatility ratio since it betrays how much an investor is rewarded https://bigbostrade.com/ for the systematic risk undertaken. Conversely, the Treynor and Sharpe ratios examine average returns for the total period under consideration for all variables in the formula (the portfolio, market, and risk-free asset). Similar to the Treynor measure, however, Jensen’s alpha calculates risk premiums in terms of beta (systematic, undiversifiable risk) and, therefore, assumes the portfolio is already adequately diversified.

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Most importantly, it tells us how much return you are getting per unit of systematic risk you are taking. You can check out our risk calculator and investment calculator to understand more about this topic. For example, assume Portfolio Manager A achieves a portfolio return of 8% in a given year, when the risk-free rate of return is 5%; the portfolio had a beta of 1.5.

This would mean that in the first fund if you undertake a risk of 1%, you stand to earn a return of 2%. On the other hand, in the second fund, if you take the risk of 1%, you stand to earn a return of 3%. So, for the same quantum of risk, the second fund offers a higher return potential and is, therefore, a better alternative.

The Treynor Index is also known as the Treynor Ratio or the reward-to-volatility ratio. IG International Limited is licensed to conduct investment business and digital asset business by the Bermuda Monetary Authority. Three-month US treasury bonds are often used as a proxy for a risk-free investment, because while no investment is completely risk-free, the risk in US treasury bonds is usually thought to be incredibly low. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Transparency is how we protect the integrity of our work and keep empowering investors to achieve their goals and dreams.

## What is Treynor Ratio?

Historically, many investors mistakenly based the success of their portfolios on returns alone. The Treynor Ratio is calculated by dividing the portfolio’s excess return over the risk-free rate by the portfolio’s beta, which measures its sensitivity to market movements. Jensen’s Alpha is a measure of the risk-adjusted return of an investment portfolio, with a focus on the portfolio’s alpha, or the excess return relative to the expected return based on the portfolio’s beta. The Treynor Ratio focuses solely on systematic risk and assumes that unsystematic risk has been eliminated through diversification. This can lead to misleading results when comparing non-diversified portfolios or portfolios with high levels of unsystematic risk. The Treynor ratio helps to make an investment decision based on the reward-to-risk ratio of a security.

Therefore, portfolio A stands as the superior investment option between the two. The Treynor Ratio can be compared and contrasted with metrics such as the Sharpe Ratio, Jensen’s Alpha, and Sortino Ratio to provide a more holistic understanding of an investment’s performance. In this example, the portfolio generated a Treynor Ratio of 6.67%, which indicates its performance relative to its exposure to systematic risk.

As mentioned earlier, the risk-free rate represents the return received on default-free securities, i.e. government bonds. J.B. Maverick is an active trader, commodity futures broker, and stock market analyst 17+ years of experience, in addition to 10+ years of experience as a finance writer and book editor. Suppose you are comparing two portfolios, an Equity Portfolio and a Fixed Income Portfolio. You’ve done extensive research on both portfolios and can’t decide which one is a better investment.

Beta measures the tendency of a portfolio’s return to change in response to changes in return for the overall market. The higher the Treynor Index, the greater the excess return being generated by the portfolio per each unit of overall market risk. First developed in 1966 and revised in 1994, the Sharpe ratio aims to reveal how well an asset performs compared to a risk-free investment.

You can use only returns as a performance indicator, but this limits your view because risk is not considered. The Treynor Ratio is also referred to as Treynor Index or risk-adjusted return. It measures the excess return that each unit of risk in a portfolio can yield. Treynor Ratio of a portfolio is an effective tool for reward vs risk analysis. Investors can use it along with other ratios to reach an accurate investment decision.