Treynor Ratio

What Is the Treynor Ratio?

The Treynor ratio, otherwise called the prize to-volatility ratio, is a performance metric for deciding how much excess return was created for every unit of risk taken on by a portfolio.

Excess return in this sense alludes to the return earned over the return that might have been earned in a risk-free investment. Despite the fact that there is no true risk-free investment, treasury bills are frequently used to imply the danger free return in the Treynor ratio.

Risk in the Treynor ratio alludes to systematic risk as measured by a portfolio's beta. Beta measures the propensity of a portfolio's return to change in response to changes in return for the overall market.

The Treynor ratio was developed by Jack Treynor, an American economist who was one of the innovators of the Capital Asset Pricing Model (CAPM).

Figuring out the Treynor Ratio

The Formula for the Treynor Ratio is:

$\begin &\text=\frac{r_p - r_f}{\beta_p}\ &\textbf\ &r_p = \text\ &r_f = \text\ &\beta_p = \text\ \end$

What Does the Treynor Ratio Reveal?

Fundamentally, the Treynor ratio is a risk-adjusted measurement of return in view of systematic risk. It demonstrates how much return an investment, like a portfolio of stocks, a mutual fund, or exchange-traded fund, earned for the amount of risk the investment assumed.

In the event that a portfolio has a negative beta, nonetheless, the ratio result isn't significant. A higher ratio result is more alluring and means that a given portfolio is logical a more suitable investment. Since the Treynor ratio depends on historical data, in any case, it's important to note this doesn't be guaranteed to demonstrate future performance, and one ratio ought not be the main factor depended upon for investing choices.

How the Treynor Ratio Works

At last, the Treynor ratio endeavors to measure how fruitful an investment is in giving compensation to investors to taking on investment risk. The Treynor ratio is dependent upon a portfolio's beta — that is, the sensitivity of the portfolio's returns to developments in the market — to judge risk.

The reason behind this ratio is that investors must be compensated for the risk inherent to the portfolio, in light of the fact that diversification won't eliminate it.

Difference Between the Treynor Ratio and Sharpe Ratio

The Treynor ratio shares likenesses with the Sharpe ratio, and both measure the risk and return of a portfolio.

The difference between the two metrics is that the Treynor ratio uses a portfolio beta, or systematic risk, to measure volatility as opposed to adjusting portfolio returns involving the portfolio's standard deviation as finished with the Sharpe ratio.

Limitations of the Treynor Ratio

A principal weakness of the Treynor ratio is its in reverse looking nature. Investments are probably going to perform and act diversely in the future than they did in the past. The exactness of the Treynor ratio is exceptionally dependent on the utilization of fitting benchmarks to measure beta.

For instance, on the off chance that the Treynor ratio is utilized to measure the risk-adjusted return of a domestic enormous cap mutual fund, it would be unseemly to measure the fund's beta relative to the Russell 2000 Small Stock index.

The fund's beta would probably be downplayed relative to this benchmark since huge cap stocks will quite often be less unstable overall than small covers. All things considered, beta ought to be measured against an index more representative of the huge cap universe, for example, the Russell 1000 index.

Furthermore, there are no aspects whereupon to rank the Treynor ratio. While looking at comparative investments, the higher Treynor ratio is better, all else equivalent, yet there is no definition of how much better it is than different investments.

Features

• The Treynor ratio is a risk/return measure that permits investors to change a portfolio's returns for systematic risk.
• The Treynor ratio is like the Sharpe ratio, albeit the Sharpe ratio utilizes a portfolio's standard deviation to change the portfolio returns.
• A higher Treynor ratio result means a portfolio is a more suitable investment.