Treynor Ratio – Meaning, Formula, Example & Calculation

Every investment you make must be based on calculations, especially ratio analysis. Successful investment strategies are created by carefully considering and analysing various metrics. Treynor Ratio is one such metric you should consider.

Understanding and using the Treynor Ratio can help you make informed investment choices. It allows you to weigh and compare the risk of your investments and helps you find the best investments at a certain level of market risk.

What is the Treynor Ratio?

The Treynor Ratio or reward-to-volatility ratio is a performance metric that calculates the returns of an investment in relation to its systemic risk. It helps you assess how well you are being compensated for taking every unit of additional risk you take on. Additional risk is the risk of an investment beyond the risk of a risk-free investment.

Treynor Ratio Formula

TR = (Return of the Portfolio – Risk-Free Rate of Return) / Beta value of the portfolio

Here's what these terms mean:

- The Return of the Portfolio is the total returns earned by your portfolio.

- Risk-Free Rate of Return is the return on an investment with zero risk; this is usually a government treasury bill or bond.

- The Beta value measures the portfolio's risk in relation to the market. A beta of 1 show that the portfolio's price moves with the market, greater than 1 indicates higher volatility than the market, and less than 1 indicates lower volatility.

Treynor Ratio in Mutual Fund Example and Calculation

Let's consider this. Suppose the risk-free return rate in the market is at 2%. This means that for an investment like a government treasury bill where the risk is considered to be zero, you get a 2% return rate.

Now, we have to choose between two mutual funds:

1. Fund A, with a return rate of 12% and a 1.2 Beta Value.

2. Fund B, with a return rate of 10% and a 0.8 Beta Value.

At an initial glance, fund A has a higher return rate. However, when you calculate the Treynor ratio for both funds, you get a different picture. Let's see how.

TR for Fund A: (12%-2%)/1.2 = 8.3%

TR for Fund B: (10% -2%)/ 0.8= 10%

Although Fund A has a higher raw return rate, Fund B has a higher Treynor Ratio. This means that Fund B would provide a higher return for every additional unit of systematic risk that you take on. So, Fund B gives you better risk-adjusted performance.

Final Thoughts

When you use Treynor Ratio be mindful that the ratio assumes that unsystematic risk has been diversified away. Also, use them in conjunction with other metrics such as the Sharpe Ratio and Jensen's Alpha.

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