Investment Performance Measurement: Treynor Ratio
Understanding the Treynor Ratio: A Measure of Market Risk
The Treynor ratio is a risk-return metric used by investors and traders to evaluate the performance of a portfolio. Named after economist Jack L. Treynor, who co-invented the Capital Asset Pricing Model (CAPM), this ratio focuses on systematic risk, the component of a portfolio's risk that is caused by market movements.
At its core, the Treynor ratio measures the excess returns of a portfolio per unit of market risk, as quantified by a portfolio's beta. Beta is a measurement of a portfolio's return change in correlation to changes in return for the market as a whole.
In the context of the Treynor ratio, excess return refers to the amount earned above what could have been made in a risk-free investment, such as U.S. treasuries. The higher the Treynor ratio, the better the performance of a portfolio when used as an analysis filter.
One key difference between the Treynor ratio and another popular risk-adjusted performance metric, the Sharpe ratio, lies in the type of risk each considers. While the Treynor ratio focuses on systematic risk, the Sharpe ratio considers total risk, which includes all volatility.
| Aspect | Treynor Ratio | Sharpe Ratio | |----------------------|------------------------------------------------------------------|-----------------------------------------------------------------| | Risk Measure | Beta (systematic risk — sensitivity to market movements) | Standard deviation (total risk — includes all volatility) | | Risk Focus | Market risk only, assumes diversification removes other risks | Total risk, both market and specific risks | | Calculation | ( \frac{R_p - R_f}{\beta} ) — excess return per unit beta | ( \frac{R_p - R_f}{\sigma_p} ) — excess return per unit std. dev. | | Best Use Case | Well-diversified portfolios where unsystematic risk is negligible| Portfolios or assets where total volatility is important | | Interpretation | How well portfolio compensates for market risk | How well portfolio compensates for overall risk |
The Treynor ratio is similar to the Sharpe ratio, but it uses beta to quantify risk instead of the portfolio's standard deviation. This makes the Treynor ratio most suitable for well-diversified portfolios where unsystematic risk is minimal.
In summary, the Treynor ratio is a valuable tool for investors seeking to understand and compare the performance of their portfolios on a risk-adjusted basis, focusing specifically on market risk.
Investors can use the Treynor ratio for evaluating their portfolios' efficiency in generating excess returns per unit of market risk, as it focuses on systematic risk. This ratio is particularly useful for well-diversified portfolios where unsystematic risk is minimal, as it utilizes beta instead of total volatility, like in the Sharpe ratio.
