The Treynor Ratio is a portfolio performance measure that adjusts for systematic risk. In contrast to the Sharpe Ratio, which adjusts return with the standard deviation of the portfolio, the Treynor Ratio uses the Portfolio Beta, which is a measure of systematic risk.
Treynor Ratio gauges how efficiently the fund manager achieves the balance between return and risk of the portfolio. The beta in the denominator indicates sensitivity of fund returns to movements of the underlying benchmark. The beta of a fund which invests in highly volatile stocks would be higher than the fund which invests in less volatile securities.
Stocks having high volatility rise and fall faster during a market rally and slump respectively. The higher the beta, higher is the sensitivity of fund returns and riskier is the investment. Thus, as compared to low-beta stocks, the stocks with high beta might generate higher or lower returns based on the market performance. In other words, the Treynor Ratio takes into account market risk while calculating risk-adjusted returns.
Risk Free Rate: The risk free rate mentioned in the formula is a theoretical concept and does not exist in reality. We can consider either 3 months treasury bill rate or retail investor could also consider saving account interest rate as risk free rate. Either of the rate of interest mentioned above gives good approximation for risk free rate.
The Difference Between the Treynor Ratio and Sharpe Ratio: The Treynor ratio shares similarities 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 utilizes a portfolio beta, or systematic risk, to measure volatility instead of adjusting portfolio returns using the portfolio’s standard deviation as done with the Sharpe ratio.
Limitations of Treynor Ratio:
- Treynor Ratio is an excellent way to analyse and identify the superior performing investment among a group of funds. Portfolios within the group of funds even though with different unsystematic risk could be ranked same if systematic risk is same. Thus portfolios within bucket even though with different level of overall risk will still be ranked same as per Treynor ratio.
- For negative values of Beta, the Ratio does not give meaningful values.
- When comparing two portfolios, the Ratio does not indicate the significance of the difference of the values, as they are ordinal. For example, a Treynor Ratio of 0.5 is better than one of 0.25, but not necessarily twice as good.