What is the Treynor Ratio
The Treynor ratio, also known as the reward-to-volatility ratio, is a metric for determining how much excess return was generated for each unit of risk taken on by a portfolio. 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. Risk in the Treynor ratio refers to market risk, as measured by beta. Beta measures the tendency of a portfolio's return to change in response to changes in return for the overall market.
Developed by Jack Treynor, the Treynor ratio is calculated as follows:
(Average Return of a Portfolio – Risk-Free Rate)
Beta of the Portfolio
Treynor Ratio: Is the Risk Worth Your Return?
BREAKING DOWN Treynor Ratio
In essence, the Treynor ratio is a risk-adjusted measurement of return, based on systematic risk. It 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. The Treynor ratio shares similarities with the Sharpe ratio. The difference between the two metrics is that the Treynor ratio utilizes beta, or market risk, to measure volatility instead of using total risk (standard deviation) like the Sharpe ratio.
How the Treynor Ratio Works
Ultimately, the ratio attempts to measure how successful an investment is in providing investors compensation for taking on investment risk. The Treynor ratio is reliant upon beta – that is, the sensitivity of an investment to movements in the market – to judge risk. The premise behind this ratio is that investors must be compensated for the risk inherent to the entire market (as represented by beta), because diversification will not remove it. All else equal, a higher Treynor ratio is better.
Limitations of the Treynor Ratio
A main weakness of the Treynor ratio is that it is backward-looking nature. Investments are likely to perform and behave differently in the future than they did in the past. The accuracy of the Treynor ratio is highly dependent on the use of appropriate benchmarks to measure beta. For example, if the Treynor ratio is used to measure the risk-adjusted return of a domestic large cap mutual fund, it would be inappropriate to measure the fund's beta relative to the Russell 2000 Small Stock index. The fund's beta would likely be understated relative to this benchmark, since large cap stocks tend to be less volatile in general than small caps. Instead, beta should be measured against an index that is representative of the large cap universe, such as the Russell 1000 index. Additionally, there are no dimensions upon which to rank the Treynor ratio. When comparing similar investments, the larger Treynor ratio is better, all else equal, but there is no definition of how much better it is than the other investments.