Macro Mondays: Treynor Ratio
A few weeks ago we discussed the usage of the Sharpe Ratio in equity research, so for this week's edition of Macro Mondays we will talk about it's counterpart: the Treynor Ratio. While Sharpe uses standard deviation, Treynor uses "beta," the volatility measurement of the broader market.
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What is the 'Treynor Ratio'?
The Treynor ratio, also known as the reward-to-volatility ratio, is a metric for returns that exceed those that might have been gained on a risk-less investment, per each unit of market risk. The Treynor ratio, developed by Jack Treynor, is calculated as follows:
(Average Return of a Portfolio – Average Return of the Risk-Free Rate)/Beta of the Portfolio
In essence, the Treynor ratio is a risk-adjusted measurement of a return, based on systematic risk. It is a metric of efficiency that makes use of the relationship that exists between risk and annualized risk-adjusted return.
How is Treynor similar to Sharpe?
The Treynor ratio shares similarities with the Sharpe ratio. The difference between the two metrics is that the Treynor ratio utilizes beta, or market risk, to measure volatility instead of using total risk (standard deviation).
How does the Treynor Ratio Work?
Ultimately, the ratio attempts to measure how successful an investment is in providing investors compensation, with consideration for the investment’s inherent level of risk. The Treynor ratio is reliant upon beta – that is, the sensitivity of an investment to movements in the market – to judge risk. The Treynor ratio is based on the premise that risk inherent to the entire market (as represented by beta) must be penalized, because diversification will not remove it.
When the value of the Treynor ratio is high, it is an indication that an investor has generated high returns on each of the market risks he has taken. The Treynor ratio allows for an understanding of how each investment within a portfolio is performing. It also gives the investor an idea of how efficiently capital is being used.
What are some limitations to the Treynor Ratio?
The Treynor ratio does not include any added value gained from active portfolio management. It is simply a ranking criterion. A list of portfolios ranked based on the Treynor ratio is useful only when considered portfolios are actually sub-portfolios of a larger, fully diversified portfolio. Otherwise, portfolios with varying total risk, but identical systematic risk, will be ranked or rated exactly the same.
Another weakness of the Treynor ratio is its backward-looking nature. Investments will almost inevitably perform differently in the future than they did in the past. For example, a stock carrying a beta of 2 will not typically be twice as volatile as the market indefinitely. By the same token, a portfolio can’t be expected to generate 12% returns over the next decade all because it generated 12% returns over the last 10 years.