What Does the Treynor Ratio Mean in Investment?

Seeking a mutual fund investment opportunity and want to know how much risk it takes to generate an optimised return? Understanding the Treynor ratio might be of help here. It lets you know how a fund might generate a potentially excess return against each unit of market risk it takes.

It is typically an effective tool to compare funds and identify one that delivers better risk-adjusted return.

With 5.20 crore Indians investing in mutual funds, if you are one of them or want to initiate a fund investment, read about this ratio here.

A Brief Overview of the Treynor Ratio

The Treynor ratio acts as a performance indicator for investments that measures the extra return an investment portfolio, such as a fund portfolio, might generate for each unit of risk linked to systematic risks or market movement.

Named after its developer, Jack Treynor, in this ratio, the extra return means the return that a fund or investment portfolio has earned beyond a risk-free level.

Generally, returns from government bonds, treasury bills and other fixed income instruments are considered risk-free. They act as a benchmark in defining the performance of a portfolio.

Investors also refer to it as the reward-to-volatility ratio. It looks at the systematic risk using beta (β), which shows how much a portfolio’s returns move in response to the overall market and determines the ultimate ratio.

Thus, by taking into account the return of a portfolio, a risk-free return amount and the beta, the Treynor ratio uses an underlying formula to arrive at a score. Using it as an investor, you might be able to determine whether a certain investment or a fund might have the potential to deliver an efficient return against the market risk it takes. Therefore, it also ensures that your investment is potentially aligned with your risk appetite and financial objectives.

How to Calculate a Treynor Ratio?

Learning the Treynor ratio meaning alone might not be enough, as learning to calculate it gives you a clear picture. Hence, you must note the Treynor ratio formula and determine the ability of generating a better risk-adjusted return of a fund while comparing:

The applicable formula to calculate this ratio for a fund is:

Treynor Ratio = (Rp – Rf) / β

Here, the Rp represents the return an investment portfolio generates over a certain period of time. From a fund perspective, if you see it generating a 15% annualised return, you represent it using Rp.

Rf is the potential risk-free return that fixed securities such as bonds, treasury bills, etc., might generate annually. The beta here is the volatility of the fund compared to its entire market.

For a bit more clarity, let us put the formula to an example for calculation:

Suppose a fund is generating a 15% return annually. Let us assume the risk-free return is currently at 5% and the fund’s beta is at 1.2.

Now, let us place this information into the above formula:

Treynor ratio = (15%−5%)/1.2 = 10%/1.2 = 0.10/1.2 = 0.0833 or 8.33%.

Thus, based on the above example, this hypothetical fund has the potential to generate a risk-adjusted return of 8.33%.

How to Interpret the Treynor Ratio?

Aside from calculating a Treynor ratio, you must also learn how to interpret it. Without a proper interpretation, you might not be able to use this ratio in favour of your investment decision:

1. Interpret a Higher Treynor Ratio

A higher Teynor ratio of a fund or an investment portfolio means that it has the potential to deliver a better risk-adjusted return on investment. Therefore, when comparing two mutual funds for investment, choosing a fund with a higher ratio might be more effective. It might have the capability to compensate for the risk it takes by generating returns.

2. Consider Risk Profile and Horizon

While interpreting this type of ratio of a fund, you must ensure that you are comparing two funds with similar risk levels. Also, you must take the same investment horizon into account while comparing funds based on this ratio.

3. Role of a Negative Treynor Ratio

It might happen that, based on historical return, risk-free rate and the beta, an investment or fund portfolio results in a negative Treynor ratio. In that case, it means that particular portfolio has failed to generate more return than the corresponding risk-free rate.

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Advantages of Using the Treynor Ratio for Investments

To understand its advantages or importance in evaluating the potential of an investment portfolio to generate risk-adjusted return, let us take a  look at some of its usages:

1. Better Performance Evaluation

The Treynor ratio of an investment portfolio lets investors see how much extra return a fund earns for each unit of market risk it takes. Referring to the above example, as the beta of the portfolio was 1.2, it means the fund is 20% more volatile compared to the market. Although the annualised return is 15%, when comparing with the risks, the true return might be 8.33%.

2. Use it for Portfolio Optimisation

You can incorporate a favourable Treynor ratio into your portfolio and optimise it to achieve a potential optimised risk-adjusted return. Suppose you locate a fund with an annualised return and a Treynor ratio of 15% and 5, respectively. While another generates a 12% return with a ratio of 7. Here, you might opt for the latter one to incorporate its favourable ratio.

3. Effective For Risk Management

As this ratio focuses on systematic risks, it clearly justifies whether the extra returns are justified based on its exposure to the prevailing market risks. Therefore, even if you are someone with a higher risk appetite, you can use this ratio. It will help to check whether the risks you are taking are, in fact, translating into better or optimised returns.

Key Limitations or Drawbacks of the Treynor Ratio

Similar to other ratios, the Treynor ratio also comes with some drawbacks or limitations. Note them to steer clear of these limitations for an informed  investment:

1. Dependency on Past Data

As you have seen in the formula, it requires the past performance of a portfolio for calculation. This acts as a limitation, as historical performance might not always be able to forecast a fund’s potential future performance. It is because trends, economic conditions, etc., are always subject to change.

2. Consideration of Only Systematic Risks

Systematic risks might be effective in understanding the actual return against taken risks. However, other risks, such as sectoral or company-specific ones, also impact the return on investment that a Treynor ratio does not consider.

3. Less Efficient for Low-Diversified Portfolios

A Treynor ratio typically works better with a well-diversified portfolio, as unsystematic risks are generally low in such cases. However, it might not be that efficient for a more concentrated portfolio, such as an equity fund, as unsystematic risks are typically higher there.

Key Difference between Treynor Ratio and Sharpe Ratio

As a mutual fund investor, you might also have encountered the term Sharpe ratio. However, that is different from the Treynor ratio in different aspects, and  you must note them before measuring the risk-adjusted return capability of a fund or a portfolio:

Things to Keep in Mind When Using the Treynor Ratio

After understanding the Treynor ratio in detail, look out for the following pointers before investing based on this ratio:

1. Updated Risk-Free Rate

While choosing an investment, say a mutual fund, you must ensure that its Tenor ratio uses the updated risk-free rate. Although it is based on fixed-income securities, it is also subject to changes.

2. Beta Sensitivity

Now that you know that the Treynor ratio relies on beta to calculate systematic risks, it is imperative to use an accurate and reliable beta coefficient. Also, while investing, such as in a mutual fund, you must bear in mind that its beta changes periodically. Thus, a fund should reflect its current beta rather than past behaviour for the ratio calculation.

Conclusion

The Treynor ratio is a financial metric to understand how much additional return an investment or fund portfolio might generate against each unit of risk it takes. Based on the past performance of a portfolio, systematic risks and risk-free return, it generates a score using an underlying formula.

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FAQ’s on Treynor Ratio

1. Is a high Treynor Ratio good?

Yes, a high Treynor ratio of a portfolio typically indicates that it has the potential to generate a better risk-adjusted return.

2. What does a negative Treynor ratio indicate?

A negative ratio here reveals that an investment portfolio or a fund has failed to generate returns beyond the risk-free return rate.

3. What is a good Treynor Ratio?

Generally, a ratio beyond 0.5% represents a good one. Any score below or close to zero typically signifies a poor performance against the prevailing market risk.

4. How to calculate the Treynor Ratio?

You must employ the formula, i.e. Treynor Ratio = (Rp – Rf) / β, to calculate a Treynor ratio for investing in an investment portfolio or mutual fund.