Treynor Ratio

Definition

The Treynor Ratio, named after economist Jack Treynor, is a performance metric for investment funds or portfolios. It measures returns earned in excess of that which could have been earned on a risk-free investment per each unit of market risk. The ratio is calculated by subtracting the risk-free rate from the portfolio’s return, then dividing the result by the portfolio’s beta.

Phonetic

The phonetics of the keyword “Treynor Ratio” is: Trey-nor Ray-shee-oh

Key Takeaways

<ol><li>Treynor Ratio, also known as the reward-to-volatility ratio, is a performance metric for determining how well an investment has compensated for each unit of systemic risk. It is calculated by taking the excess return over the risk-free rate divided by the portfolio’s beta.</li><li>It is predominantly used to evaluate the performance of a portfolio or fund manager. A higher Treynor Ratio implies that the portfolio or fund manager achieved higher returns while managing systemic risk effectively.</li><li>The Treynor Ratio is most useful when comparing funds or portfolios that are composed of diversified investments. However, it only takes into consideration systemic risk (represented by beta) and ignores unsystemic risk. Therefore, it works best for well-diversified portfolios.</li></ol>

Importance

The Treynor Ratio is important in business and finance because it is a performance metric for determining how well an investment has been when taking into consideration the systematic risk involved. Named after Jack Treynor, it is also known as the reward-to-volatility ratio. It is particularly useful in comparing the risk-adjusted performance of different portfolios or funds. A higher Treynor Ratio indicates a more desirable portfolio performance, demonstrating a superior risk-reward balance, and vice versa. Thus, it provides valuable insights for financial analysts and investors in their decision-making process to opt for more profitable and less risky investments.

Explanation

The purpose of the Treynor Ratio, a financial metric, is to assist investors and analysts in determining the level of risk undertaken to produce a certain level of return. By relating the risk premium (the difference between the average return of a portfolio and the risk-free rate) to “systematic risk” , this ratio gauges the reward efficiency – that is, how much return is generated per unit of risk. This ratio, developed by Jack L. Treynor, is particularly useful for comparing portfolios that have disparate risk levels.The Treynor Ratio evaluates the effectiveness of the portfolio’s risk management strategy and guides investment decisions. It assesses whether the risk undertaken was justified by the returns, aiding investors in balancing their risk-return preferences. It is crucial to note that the higher the Treynor Ratio, the more desirable the portfolio is, as it suggests that the portfolio is earning more return per unit of risk. This metric therefore plays an integral part in optimizing portfolio performance and decision-making in financial management.

Examples

The Treynor Ratio, developed by Jack Treynor, is a performance metric for determining how well an investment has done in comparison to the risk-free rate of return, given its level of market risk. Here are three real-world examples:1. Index Mutual Fund: Consider an index mutual fund that over the past year has yielded a return of 8%, while the risk-free rate (such as a 3-year U.S. Treasury Bill) has yielded 2%. If the beta value of the fund (the measure of market risk) is 1.2, then the Treynor ratio would be (8%-2%)/1.2 = 5.2. Large-cap Stocks: An investment portfolio is heavily invested in large-cap stocks. Over a specific period, the portfolio gives a return of 12%. Meanwhile, the risk-free rate for the same period is 3%. The beta value, a measure of the portfolio’s relative volatility, is 1.5. The Treynor ratio is then calculated as (12%-3%)/1.5 = 6.3. Pension Funds: A pension fund has achieved an average return of 10% over the last five years, while the returns on risk-free investments like T-bills over that same period is 4%. The beta of the pension fund is found to be 1.3. The Treynor ratio is then (10%-4%)/1.3 ≈ 4.62.In all of these cases, the Treynor ratio provides a measure of the excess return earned above the risk-free rate, per unit of market risk, which helps investors assess the performance of their investments in relation to the risks involved.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Portfolio Management
• Risk-adjusted Performance
• Systematic Risk
• Beta Coefficient
• Expected Return

Sources for More Information

• Investopedia
• Corporate Finance Institute
• The Balance
• Morningstar