The Treynor Ratio is also known as the โreward-to-volatility ratioโ.
It measures the returns a funds gives with respect to its volatility.
A higher Treynor ratio means that the fund not only performs well but is less risky than the general market.
The following example should help you understand the concept of โTreynor Ratioโ.
- There are two batsmen โAโ and โBโ.
- In a recent match, โAโ scored 50 while the average score of his team was 25.
- In another match, โBโ scored 100 while the average score of his team was 60.
Which of them is a better batsman in comparison to their respective teamโs performance?
Applying the โTreynor ratioโ principle, lets divide the batsmanโs score by the teamโs average score, we get the ratios as follows:-
Ratio for A = 50/25 = 2
Ratio for B = 100/60 =1.67
- Although โBโ scores a century, his performance as compared to the overall teamโs performance was better by 1.67 times whereas โAโ who only scored 50 performed twice as good as the rest of his team.
- Hence from this perspective, the performance of the batsman scoring 50 was better than the performance of the batsman scoring 100 runs.
- Thus, if two funds A & B have similar returns but A has been more volatile as compared to the market whereas B has been less volatile as compared to the market, the relative performance of B would be better than A, even though otherwise their returns are similar.
- A higher Treynor Ratio indicates that the fund has performed well not only in terms of returns but also in terms of volatility (i.e., it has displayed less riskiness)
How is the Treynor ratio useful?
- It is useful to indicates how much return an investment, such as a portfolio of stocks, a Mutual fund or an exchange traded fund, earned for the amount of risk the investment assumed.
- If you are considering two investments, you could calculate the Treynor ratio on each to help to assess which one provides better returns for the risk. When the Treynor value is negative, the ratio is not as useful.
The main pitfalls of the Treynor ratio include the fact that it is only backward looking and historical returns and betas may not accurately reflect the future. Stocks have pre-calculated betas but, for other markets, they will likely need to be manually calculated.