What is a Treynor Ratio?
The Treynor Ratio concept was developed by Jack Treynor, an American economist who was known as a scholar of Investment Management. Treynor Ratio is a measure of excess reward/return for the excessive risk borne by the investor. In other words, as it tries to find out the extra or additional returns earned, this ratio is also termed as Reward-to-Volatility or Reward-to-Variability Ratio. It is a measure of reward for risk.
Investments vis-a-vis Treynor Ratio
Let us first understand the concept of investments and the Treynor Ratio before we discuss and understand the ratio itself. Few universal concepts concerning investments are:
- All investors under a given situation would like to earn the highest return from the proposed investments with the lowest amount of risk.
- The universal principle of investments is “Higher the return; higher is the amount of risk Or lower the quantum of risk, lower will be the return from that investments.”
- Moreover, all investments generally have some amount of risks involved, and it may vary from the lowest or negligible to high.
- And this quantum of varying risk happens due to the volatile behavior of the market as well as dynamic changes continually happening in the economy and investment ecosystem.
- Hence, all analyses and investments are always said to be “subject to market-risks,” and this is called the “Systematic-risk.”
- And all these universal rules also suggest that if an investor is taking a risk, he should be rewarded adequately for that extra effort.
Evolution and Components
If we look with an investment concept perspective, we need an indicator to assess the quantum of risk and quantum of extra return for the extra effort of the investor. That is where the Treynor Ratio got evolved to address this requirement.
Under this concept, we need to assess three items:
As we said, we need to get the extra return to take care of the additional risk. So to assess what excess return the proposed investment is giving us, we need to have a reference point, in comparison to that this is the extra return. This reference rate is the Risk-Free Return Rate, where an investor’s return is almost with zero or negligible return rate. So, what could be a better representation for such a risk-free return rate than the return available on government securities. So typically, the rates available or offered on government bonds (Treasury Bills, etc.) is taken as the benchmark rate.
Market Return of Investments
For comparison purposes, we need to calculate the anticipated or estimated or offered return of the proposed security/financial instrument.
Market Risk (Beta)
First two points have given us the rate of return, and now we need to evaluate the quantum of risk the proposed security/investment has. Then only we will be able to identify and understand whether the market return is adequately compensating the market risk.
Again, every market security usually offers a higher rate of return than the risk-free return. In other words, there should be a reward for sustaining volatility or investing in a high-risk product.
Therefore, through the Treynor Ratio, we measure the excess reward/return for the excessive risk borne by the investor. In other words, the ratio tries to find out the extra or additional returns earned. Moreover, the excess or additional return that this ratio assesses is the return that had been made or could be earned over and above risk-free return.
Treynor Ratio takes into account the Beta (β) factor of risk to help evaluate the portfolio performance.
β = Market Risk
Treynor Ratio Formula is as follows:
T = RI – Rf /βi
T = Treynor Ratio,
Ri = Market Rate of Return of security,
Rf= Risk-free rate of return,
βi = Beta (volatility of market)
Treynor Ratio is extensively useful in measuring the excess return against the risk attached to particular security over the risk-free rate of return considering the additional risk. Though the securities or investment portfolio is diversified to balance the risk and return, the systematic risk always persists due to the volatile behaviour of the market. This ratio provides better analysis and evaluation of the entire investment portfolio for better returns.
It suggests whether a security is worth investment to sustain the volatility of the market.
A higher Treynor Ratio is better.
Uses / Benefits of Treynor Ratio
- This ratio is the best measure for a diversified portfolio.
- It helps to assess and analyze the performance of each security in the portfolio.
- It helps in managing investment decisions for improving and optimizing the portfolio returns.
- Treynor Ratio is one of the tools to assess and manage the systematic risk.
- It is a Reward v/s Risk evaluation.
Applicability of Treynor Ratio
Investors, while investing in risky securities, such as Mutual Funds, need not rely on NAV or index evaluation, solely. It is noteworthy that assessing past returns might lead to inaccurate results; because these are only the indicators of the extent of risk. Treynor Ratio takes in to account the β factor of risk i.e., the systematic risk. Hence, the Treynor Ratio provides a better way to match the performance of a portfolio after considering the market volatility and risk.
Treynor Ratio evaluates the risk-adjusted return of an investment portfolio. It determines whether security or investment is significantly outperforming the average rate of return or not.
Let us understand by an example as under:
If the fund’s Average Return is 12%, the risk-free Rate of Return is 6%. The difference is 6%. Beta β of the fund is 2%. Therefore, under this given situation, the Treynor ratio will be 3:1. It concludes that the fund has earned three units of return against one unit of market risk.
Limitations of Treynor Ratio
- It is based on the past performance of the securities.
- It takes into account the past volatility behaviour of the market.
- Investments might perform better, and the market might behave differently in the future, which is not considered in the Treynor Ratio concept.
- The calculations are based on benchmark beta Whereas, long cap and small-cap Mutual Fund investment have relatively different volatility as per the Russell 2000 Small Stock index and Russell 1000 index.
- Treynor Ratio has no dimensions of ranking as to “how much higher Treynor Ratio is Better.”