Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Additionally, there are no dimensions upon which to rank the Treynor ratio. When comparing similar investments, the higher Treynor ratio is better, all else equal, but there is no definition of how much better it is than the other investments. The premise behind this ratio is that investors must be compensated for the risk inherent to the portfolio, because diversification will not remove it. Moreover, the accuracy of TR depends on whether one applies an appropriate index in its calculation.
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.
- 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 ratio compares your returns against underlying market volatility and systematic risk.
- Although Fund B seems to be a better choice based on the return, higher returns are due to the high risk taken by that fund.
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 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.
It is a performance metric that measures the return a portfolio generates in excess of the risk-free rate and divides that by the systematic risk. As a measure of the risk-adjusted return of a financial portfolio, Treynor Ratio can be used to compare the performance of investments in different asset classes. Jack Treynor is credited with introducing the Treynor’s ratio that has become a common yardstick to measure the risks taken vis-a-vis the returns generated by a mutual fund scheme.
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.
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One of the primary limitations of this metric is that it does not apply when the beta value of a portfolio is negative. Thus, it does not facilitate comparison between funds if one of them holds a negative beta value. The risk-free rate is the return on a theoretically risk-free investment, such as a government https://bigbostrade.com/ bond. This rate is used as a benchmark for comparing the performance of riskier investments. Well, investing in India’s top 50 companies through the Navi Nifty 50 Index Fund could be a cost-effective way to do so. This is similar to the Sharpe ratio, but it only applies to a portfolio’s downside risk.
The Difference between Treynor Ratio and Sharpe Ratio
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.
How is the Treynor Ratio Calculated?
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.
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.
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.
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 best investment opportunities 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.
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.
If one were to use the Nifty 50 to determine the TR of a portfolio consisting mainly of small and mid-cap stocks, then it would not work. My Accounting Course is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Enhancements to the Treynor Ratio include the Modified Treynor Ratio, the Treynor-Black Model, and the incorporation of alternative risk measures like Value-at-Risk (VaR) and Conditional Value-at-Risk (CVaR).