What is Treynor Ratio, How is It Calculated and Why Do Traders Use It?
A ratio analysis is often critical for investment decisions. Investors need to assess metrics and check if they align with their goals. This is because the ratios offer meaningful insights into the investment and its profitability.
Investors can measure the performance of their portfolio and assess if the trading risk is worth it using the Treynor ratio. Treynor ratio falls under the category of performance metrics and is a critical tool for decision-making in investing. It helps to compare investments based on their risks and rewards.
This article discusses how the Treynor ratio can be calculated using the Treynor formula. It also talks about the uses of the Treynor index in trading.
What is Treynor Ratio?
The Treynor ratio is a measure of the amount of excess return each unit of risk in an investment or portfolio can yield. It is also referred to as the risk-adjusted return or the Treynor index.
Excess return means the return earned over the risk-free rate of return. The risk-free rate can be regarded as the amount one gets in a savings account or the rate offered on US treasury bills. In the case of both these investments, the chance of losing money is negligible. The excess return rate is the difference between investment yield and the risk-free rate for a year.
For instance, if the investment returns 9% in one year and the risk-free rate is 1% per annum, the excess rate will be 8%.
One of the most important factors that the Treynor ratio uses to assess risk is beta, which is an integral part of fundamental analysis. Beta measures the movement of a stock relative to a prominent market index. The risk represented by the market index is the inherent risk associated with an investment. It is also called systematic risk. If the beta of a stock is negative, the Treynor ratio is not as useful. A negative beta indicates that the movement in stock prices is in the opposite direction as compared to the movement of the index.
Also Read: What is Liquidity Coverage Ratio? Formula and Calculation
How is Treynor Ratio Calculated?
Treynor Ratio Formula
The Treynor Index can be calculated using the formula below:
Treynor ratio = (Rp-Rf)/ βp
In this formula,
Rp is the risk associated with the portfolio
Rf is the risk-free rate
βp is the beta of the portfolio
The information required to calculate the Treynor ratio for an individual stock includes the annual return of the stock, the beta for the stock, and the risk-free rate. Suppose the average returns of the stock have been 20% for the past many years and the beta of the stock is 1.3. If the risk-free rate is 1%, below is the calculation based on the Treynor ratio formula:
Treynor ratio = (20–1) / 1.3 = 14.61
Now, suppose a beta of 2.7
Treynor ratio = (20 – 1) / 2.7 = 7.03
Although the amount returned by the stocks was the same, the Treynor ratio shows that the stock with 1.3 beta is a low-risk option. Beta is an indicator of risk, as it determines the movement of a stock relative to an index.
In the case of multiple assets, portfolio return, the average beta of the portfolio and risk-free rate are required for the calculation. The average calculation involves multiplying the returns with the weighting of stock in account and adding up all the returns. Similarly, for beta, multiply it by weight in the portfolio and add the numbers to yield the average beta of the portfolio.
For instance,
Take a simple 2 stock portfolio. Suppose 60% of the portfolio is made of Stock A, whose beta is 1.7 and returns 10%. The remaining 40% is invested in Stock B, which has a beta of 2.1 and yields 17%.
Portfolio Return = (0.6 x 10) + (0.4 x 17) = 12.8%
Beta for the portfolio = (0.6 x 1.7) + (0.4 x 2.1) = 1.86
Risk-free rate = 1%
Treynor ratio = (12.8% – 1%) / 1.86 = 6.34
Treynor Ratio Example
Imagine a fund with an average return of 12% andβ 2%. If the risk-free rate of return is 6%, the Treynor ratio of the mutual fund will be 3:1. This means that the fund has 3 units of excess return per unit of risk.
Uses of Treynor Ratio in Trading
Treynor index acts like a decision-making tool in trading. It isn’t as valuable in short-term trades as it is based on long-term values. These values may not apply to trades that last just a few weeks or less.
While comparing two investments, investors can calculate the Treynor ratio of each to evaluate which one offers more returns for every unit of risk. If the investments yield similar returns, a higher Treynor ratio is better. The ratio is not a useful indicator when the Treynor value is negative.
Treynor ratio is also helpful when shortlisting mutual funds. Usually, a mutual fund with a higher Treynor ratio is considered a better investment than one with a lower Treynor Ratio. However, you must use a ratio based on your portfolio size and type. In case the portfolio is well diversified, the risk will be low and the total risk will be similar to the market risk.
Thus, Sharpe and Treynor Ratios will offer similar results, i.e. they will come up with the same order of funds. With non-diversified portfolios, market risk is a better measure of risk. Thus, both ratios will rank mutual funds differently. Treynor ratio will consider the non-diversifiable element of risk and yield additional risk-adjusted performance metrics.
If adding a new fund to the portfolio reduces its Treynor Ratio, it increases the risk involved without adding anything to the returns. This will help to reconsider investing in the new fund.
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Benefits of Treynor Ratio
- Treynor ratio measures portfolio performance and helps to make changes accordingly
- It helps to assess whether an investment is worth the risk
- Investors can evaluate the performance of each security
- It helps to manage systematic risk
- The goal of the Treynor ratio is not to stay clear of risk but to conduct a reward v/s risk evaluation
Limitations of the Treynor Ratio
The Treynor ratio is used extensively to measure the risk-adjusted return potential of investments. However, investors need to understand that there are also limitations to this approach.
While Treynor Ratio analyses and identifies investments that perform well among a group, it is effective only when it is a part of a broad portfolio. When the portfolios being compared have similar systematic risks but also a total variable risk, Treynor Ratio doesn’t offer the right picture.
The basis of the Treynor Ratio calculation is historical data, and it is, thus, indicative of the past behaviour of portfolios. Treynor Ratio portfolio performance doesn’t take future risks into account and there is no guarantee that the past performance will be repeated. Market dynamics will impact the vulnerability of the portfolio based on the volatility of constituent securities.
The Difference between Treynor Ratio and Sharpe Ratio
Both Treynor ratio and Sharpe ratio are similar. They differ only based on the denominators in their formulae. While the Treynor ratio uses beta as a risk assessment tool, the Sharpe ratio assesses risk using the standard deviation of returns. Standard deviation is a measure of the extent of dispersion of returns from the mean or average.
If the average annual return of a stock is 12% but it deviates a lot, the standard deviation will be higher.
Both beta and standard deviation have their limitations. Beta establishes volatility by comparing an asset to an index, which might not always be useful. This is because some assets may not have a relative index to compare with. Standard deviation, on the other hand, works well only with evenly distributed data. Since stock returns can be erratic, this is not a very accurate measure.
It is important to understand that both these ratios are just tools and shouldn’t be used as sole metrics to make trading decisions.
Also Read: What is Put Call Ratio and How to Calculate It?
Final Word
Treynor Ratio of a portfolio is an effective tool for reward vs risk analysis. However, it indicates past performance and has certain limitations. Investors can use it along with other ratios to reach an accurate investment decision.
FAQs
Ans. The Treynor Ratio reveals whether the return on a particular investment is worth the trading risk. This means it shows how much return an investment instrument yields, based on the risk it poses.
Ans. The Treynor ratio helps to make an investment decision based on the reward-to-risk ratio of a security. It also helps in comparing and shortlisting mutual funds.
Ans. 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.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
