The Treynor ratio is a tool in portfolio analysis that helps investors assess how well a portfolio compensates them for taking on market risk, also known as systematic risk. This portfolio ratio shows how much return an investor can expect for each unit of market risk. It offers insight into how efficiently a portfolio’s manager is balancing risk and return and can be useful for comparing portfolios or funds that might have different risk levels. Due to some limitations, it is often used in conjunction with other performance metrics.
If you want to build an investment portfolio, a financial advisor can help you analyze and manage investments.
What Is the Treynor Ratio?
The Treynor ratio is a risk-adjusted metric that evaluates portfolio performance in relation to systematic risk, also called market risk. Named after American economist Jack Treynor, this ratio is calculated by dividing the excess return of a portfolio over the risk-free rate by its beta.
A high Treynor ratio figure suggests that the portfolio is delivering strong returns for its level of risk, while a lower ratio may indicate underperformance relative to market volatility. Note that this metric specifically isolates market-related volatility while ignoring diversifiable risk, making it particularly useful for portfolios that are already well-diversified.
By focusing only on systematic risk, the Treynor ratio allows investors to assess how much return they are getting for each unit of market risk taken. It can offer a clearer view of risk-adjusted performance for portfolios that track broader markets.
How to Calculate It
The Treynor ratio is calculated by subtracting the risk-free rate such as a government bond yield from the portfolio's return, then dividing this figure by the portfolio's beta. Beta measures how sensitive the portfolio is to market movements, providing a way to quantify systematic risk.
The formula is:
Treynor Ratio = (Portfolio Return – Risk-Free Rate) / Beta
A higher Treynor ratio suggests the portfolio is delivering more return per unit of market risk, while a lower ratio could indicate insufficient compensation for the risk taken. This calculation is particularly useful for comparing portfolios with similar betas.
Let's say a portfolio has an annual return of 12%, a risk-free rate of 3%, and a beta of 1.2. To find the Treynor ratio, first subtract the risk-free rate from the portfolio's return (0.12 – 0.03 = 0.9), then divide this result by the portfolio's beta (0.9 ÷ 1.2 = 0.75). The Treynor ratio of 0.75 means that for every unit of market risk, the portfolio delivered 7.5% in excess returns over the risk-free rate. This suggests that the portfolio is effectively compensating for the systematic risk it carries.
What Is a Good Treynor Ratio?
A good Treynor ratio typically reflects a higher return relative to the portfolio's exposure to market risk. In general, a positive Treynor ratio indicates that a portfolio is earning more than the risk-free rate per unit of market risk, which is considered favorable. Ratios greater than 0.5 are often seen as strong, while those closer to 1.0 suggest exceptional performance in relation to risk.
However, what qualifies as a good Treynor ratio can vary depending on market conditions and the investment strategy. For example, in bull markets, higher Treynor ratios are expected, as returns typically exceed risk-free rates by a larger margin.
With bear markets, on the other hand, lower ratios might still be acceptable if they demonstrate risk-adjusted returns. Ultimately, comparing the Treynor ratio of a portfolio to similar investments or benchmarks provides a more accurate gauge of performance.
Limitations of the Treynor Ratio
While the Treynor ratio offers valuable insights into a portfolio’s risk-adjusted returns, there are several limitations to consider. Understanding these drawbacks can help investors use the metric more effectively in evaluating their investments. Here are four to consider:
- Focus on systematic risk only: The Treynor ratio relies on beta, which measures market-related or systematic risk. It ignores unsystematic risk, such as company-specific or sector-specific risks. This makes the metric less effective for portfolios that aren't well-diversified.
- No measure of return volatility: The ratio doesn't capture the volatility of a portfolio's returns. A high Treynor ratio could still belong to a portfolio with large short-term fluctuations, which may not appeal to risk-averse investors.
- Dependence on the risk-free rate: The Treynor ratio compares returns to the risk-free rate, which can fluctuate over time due to economic conditions. This may affect the consistency of the ratio when comparing performance across different periods.
- Limited use in isolation: The Treynor ratio is best for comparing multiple portfolios with similar systematic risks. By itself, it doesn't provide a complete performance picture and should be complemented by other metrics like the Sharpe ratio or standard deviation.
Using the Treynor Ratio
The Treynor ratio is most effective when evaluating a well-diversified portfolio that is primarily exposed to systematic risk. In these cases, unsystematic risks, like company-specific or sector-specific volatility, are assumed to be minimized or eliminated. The Treynor ratio helps investors assess how well the portfolio compensates for market risk alone, making it useful for portfolios driven by their beta, or sensitivity to broader market trends.
Investors also use the Treynor ratio for comparing portfolios with similar beta values. This allows for an apples-to-apples comparison of how well each portfolio performs relative to its exposure to market movements. When two portfolios have similar market sensitivity but varying returns, the Treynor ratio helps determine which one is delivering better risk-adjusted performance relative to the market.
Bottom Line
The Treynor ratio can offer valuable perspectives on risk-adjusted returns. This ratio focuses on systematic risk, making it useful for evaluating diversified portfolios that are primarily exposed to market volatility. Its limitations include not accounting for unsystematic risk and being dependent on the risk-free rate. It is mostly effectively used in conjunction with other risk-adjusted performance metrics.
Tips for Investing
- A financial advisor can help you create a personalized portfolio for your investments. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
- Any time you consider selling an asset for a profit, take a moment to estimate how much capital gains tax you may owe using SmartAsset's capital gains tax calculator.
Photo credit: ©iStock/Jinli Guo, ©iStock/Sean Anthony Eddy, ©iStock/eepak Sethi
The post How to Use the Treynor Ratio: Definition and Formula appeared first on SmartReads by SmartAsset.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
