Measuring a Portfolio’s Performance Leave a comment
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.
- A higher Treynor ratio is preferable because it denotes higher returns for each unit of risk.
- The basis of the Treynor Ratio calculation is historical data, and it is, thus, indicative of the past behaviour of portfolios.
- The Treynor ratio is reliant upon a portfolio’s beta—that is, the sensitivity of the portfolio’s returns to movements in the market—to judge risk.
- But since the ratio is derived using historical data and past performance, it is an imperfect indicator of future performance (and should be evaluated alongside other relevant metrics).
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.
How to calculate the Treynor ratio
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.
Beta as a Risk Measure
A negative Treynor ratio indicates that the investment has performed worse than a risk-free instrument. A security’s or portfolio’s beta is a measurement of the volatility of returns relative to the overall market. It shows how sensitive the portfolio’s returns are to movements in the market.
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The rate of return may go up or down, depending on the macroeconomic factors. Treynor Ratio might be an excellent way to analyse and identify the superior performing investment among a group of funds. But it is valid only when the given investment is a subset of the broader portfolio. Instances where the portfolios have similar systematic risks but total variable risk, then the Treynor Ratio will provide them with the same rank even though it is not valid.
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 pips trading 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 suggests that the investment is providing a better risk-adjusted return. This is represented by the numerator of the equation which is the portfolio return minus by risk-free rate. Portfolio return is the portfolio actual return over the given period of time. 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. Rather than measuring a portfolio’s return only against the rate of return for a risk-free investment, the Treynor ratio looks to examine how well a portfolio outperforms the equity market as a whole.
Excess return in this sense refers to the return earned above the return that could have been earned in a risk-free investment. Although there is no true risk-free investment, treasury bills are often used to represent the risk-free return in the Treynor ratio. Hence, in this situation, the ranks given by the two ratios will be different. Hence, the Treynor Ratio gives additional risk-adjusted performance metric by considering the non-diversifiable element of risk. Thus, having a clear understanding of them and applying metrics correctly can facilitate more effective decisions.
A portfolio with a higher beta has a bigger return potential, but it also has a bigger risk. So, beta is a measure of systemic risk, which is the risk in a portfolio that cannot be offset by diversification within the same market. Risk in the Treynor ratio refers to systematic risk as measured by a portfolio’s beta. Thus, the Treynor Ratio of a mutual fund indicates how well you will be rewarded for taking the risk of investing in a particular mutual fund scheme.
It shows that although X provides higher returns, it does not justify the risk such a fund assumes. Y compensates better for the assumed risk and, thus, is a better choice. Treynor ratio can only be applied to well-diversified portfolios whereas Sharpe Ratio can be applied to all kinds of portfolios.
Treynor Ratio FAQs
This metric is particularly useful for investors who are more concerned about the potential for losses than the overall volatility of their investments. Portfolio managers can use the Treynor Ratio to assess the risk-adjusted return of their investment portfolios and make informed decisions https://bigbostrade.com/ about asset allocation and risk management strategies. The portfolio return is the total return generated by an investment portfolio over a given period. It includes capital gains, dividends, and interest payments, and can be expressed as a percentage of the initial investment.
As a result, this ratio is best applied to an investment such as a mutual fund. The Jensen ratio measures how much of the portfolio’s rate of return is attributable to the manager’s ability to deliver above-average returns, adjusted for market risk. A portfolio with a consistently positive excess return will have a positive alpha, while a portfolio with a consistently negative excess return will have a negative alpha. Usually, a mutual fund with a higher Treynor ratio is considered a better investment than one with a lower Treynor Ratio. In case the portfolio is well diversified, the risk will be low and the total risk will be similar to the market risk. The Traynor Index indicates how much return an investment, such as a portfolio of stocks, a mutual fund, or exchange-traded fund, earned for the amount of risk the investment assumed.
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 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.
In the same year, Portfolio Manager B achieved a portfolio return of 7%, with a portfolio beta of 0.8. The Traynor Index was developed by economist Jack Treynor, an American economist who was also one of the inventors of the Capital Asset Pricing Model (CAPM). The Sharpe ratio divides the equation by a standard deviation of the portfolio, which is the biggest difference between the Sharpe ratio and the Treynor ratio. Standard deviations can help to determine the historical volatility of an asset. Beta on the other hand, is a measure of an asset’s volatility as it relates to the overall market. The Treynor ratio compares your returns against underlying market volatility and systematic risk.
