Some investments take on more risk than others. But how do you know if the returns were worth it? The Treynor Ratio is one way investors assess whether a portfolio or fund delivered enough return for the risk taken.
It’s a tool often used by fund managers and analysts, but is it useful for everyday investors? And how does it compare to other performance measures?
In this article, we’ll break down how the Treynor Ratio works, when it’s used and what it can (and can’t) tell you.
What is the Treynor Ratio?
The Treynor Ratio measures how much excess return an investment or portfolio has generated for each unit of market risk taken.
What is its purpose in finance and investing?
The Treynor Ratio helps investors and fund managers assess whether the return on an investment or portfolio is worth the risk. It focuses only on systematic risk – the type of risk that comes from overall market movements and can’t be reduced through diversification.
Why does it matter?
Not all risk comes from the overall market. Some risks can be reduced through diversifying across regions and assets. Other risks, like market downturns , affect nearly all investments.
The Treynor Ratio is particularly useful for well-diversified portfolios , where most risk comes from the market rather than individual assets .
Who created it?
The Treynor Ratio was developed by Jack Treynor , an economist and key figure in modern portfolio theory. He introduced the measure in the 1960s as part of his research on capital asset pricing models. His work helped shape how investors and fund managers assess risk-adjusted returns, influencing many of today’s investment strategies.
How is the Treynor Ratio calculated?
The Treynor Ratio uses a simple formula:
Treynor Ratio = (Expected portfolio return - Risk-free rate) ÷ Beta
Breaking it down
- Expected portfolio return – The projected return of an investment or portfolio over a period.
- Risk-free rate – The return from a low-risk investment, such as government bonds .
- Beta – A measure of how much an investment moves compared to the overall market. A beta of 1 means it moves in line with the market, while a higher beta means greater swings.
Example calculation
A fund manager is analysing a portfolio with an expected return of 10% , a risk-free rate of 3% , and a beta of 1.2 .
Treynor Ratio = (10 - 3) ÷ 1.2
Treynor Ratio = 7 ÷ 1.2
Treynor Ratio = 5.83
A higher Treynor Ratio suggests a portfolio delivered more return per unit of market risk. However, as mentioned, it doesn’t account for all types of risk.
How the Treynor Ratio is used in real-world investing
The Treynor Ratio helps compare portfolios, assess fund performance, and refine investment strategies.
How fund managers and analysts use it
- Evaluating fund performance – Fund managers use the Treynor Ratio to measure whether their strategies have delivered returns that justify the market risk taken.
- Comparing actively managed funds – Analysts apply the ratio to compare different funds, especially those aiming to outperform the market.
- Optimising asset allocation – Some fund managers adjust portfolio holdings based on Treynor Ratio trends, aiming to improve risk-adjusted performance.
A practical example: comparing two investment options
An investor is choosing between two exchange-traded funds (ETFs) that track different segments of the market. Here’s how they compare:
- ETF A has an expected return of 12% , a risk-free rate of 3% , and a beta of 1.5 .
- ETF B has an expected return of 10% , a risk-free rate of 3% , and a beta of 1.0 .
Now, let’s calculate the Treynor Ratio for both:
- ETF A: (12 - 3) ÷ 1.5 = 6.00
- ETF B: (10 - 3) ÷ 1.0 = 7.00
At first glance, ETF A seems more attractive because it has a higher return, but it also carries higher market risk. ETF B has a slightly lower return but with less market volatility.
Even though ETF A had a higher return, ETF B had a better Treynor Ratio, suggesting it provided more return per unit of market risk.
This could be useful for an investor who prefers an ETF with smoother performance and lower exposure to market movements. However, this doesn’t mean ETF A is a bad choice it depends on your risk tolerance and financial goals.
Note the example above is for educational purposes only and does not consider factors like fees, taxes, or market conditions, which can impact actual investment returns. The Treynor Ratio is just one way to compare investments and doesn’t guarantee future performance.
How can investors use the Treynor Ratio?
As mentioned, the Treynor Ratio is most useful when comparing well-diversified portfolios, ETFs, and managed funds , where systematic risk is the main factor affecting returns.
Comparing ETFs, managed funds, and portfolios
Investors often use the Treynor Ratio to compare different funds or portfolios with similar market exposure. The ratio works best when comparing investments within the same asset class or risk profile. Since it focuses only on market risk, it can help assess whether an investment has efficiently taken on risk to generate returns.
While a higher Treynor ratio may look appealing, as mentioned, past performance doesn’t guarantee future results. You should also consider other factors, like investment fees, taxes and the broader market environment.
Assessing risk-adjusted returns
The Treynor ratio can also be used to analyse how well a portfolio has performed relative to its market risk. Investors and fund managers use it to assess whether a portfolio’s returns were reasonable given the risk exposure.
If a fund manager actively adjusts a portfolio’s holdings, the Treynor Ratio can help measure whether those adjustments resulted in better risk-adjusted returns. And as touched on earlier, it helps investors see if a portfolio earned enough return for the market swings it experienced.
When the Treynor Ratio isn’t enough
Despite its usefulness, the Treynor Ratio has limitations and may not always be the best tool for assessing risk-adjusted performance. Here’s why:
- It ignores total risk , meaning it doesn’t account for risks that can be diversified away, such as sector-specific downturns or company issues.
- The ratio depends on beta , which measures how much an investment moves compared to the overall market. Beta values change over time, so past figures may not reflect future risk exposure.
- It works best for well-diversified portfolios . If an investment holds a small number of stocks or is concentrated in one industry, the ratio may not provide a complete picture.
Because of these limitations, investors often use the Treynor Ratio alongside other risk measures, like the Sharpe Ratio or Sortino Ratio . This can help build a clearer picture of portfolio performance.
Treynor Ratio vs. Sharpe ratio: key differences
The Treynor Ratio and Sharpe Ratio both measure risk-adjusted returns but focus on different types of risk. Investors and fund managers use them to compare portfolios, but choosing the right metric depends on the investment type.
The Sharpe Ratio adjusts for total risk, including market risk and investment-specific risk. The Treynor Ratio adjusts only for market risk. This is why the Treynor Ratio is more relevant for well-diversified portfolios, while the Sharpe ratio can be useful for individual investments or concentrated funds.
Here’s a side-by-side comparison:
|
Feature |
Treynor Ratio |
Sharpe Ratio |
|
Risk type measured |
Market risk (systematic risk) |
Total risk (market risk + investment-specific risk) |
|
Formula |
(Expected return - Risk-free rate) ÷ Beta |
(Expected return - Risk-free rate) ÷ Standard deviation |
|
Best used for |
Well-diversified portfolios |
Any investment, including individual assets and concentrated portfolios |
|
Key assumption |
Market risk is the only risk that matters |
All risk affects performance equally |
|
Limitation |
Not useful for portfolios with significant investment-specific risk |
Penalises all volatility, including positive price movements |
Treynor Ratio: useful, but should you rely on it?
The Treynor Ratio can be a handy tool for comparing ETFs, managed funds, and portfolios, especially if you’re looking at market risk. It puts returns into perspective, but it’s not the only measure that matters.
Since it relies on beta, it assumes market risk is the biggest factor affecting performance. That might be true for diversified portfolios, but not always for individual stocks or sector-focused funds.
No single metric tells the full story. That’s why the Treynor Ratio works best when used alongside other performance measures. Investing isn’t about finding the perfect metric but understanding risk and making informed choices. The more tools you have, the better prepared you’ll be.
Happy investing!
