A beta above 1 means a fund is more volatile than the index and vice versa. This measure gauges the returns from a collection of securities’ above a risk-free rate, adjusted by the beta value. Hakan Samuelsson and Oddmund Groette are independent full-time traders and investors who together with their team manage this website. For instance, it would not be appropriate to use the Dow 30 Index to measure the beta of a mutual fund whose portfolio consists of small-cap companies.

For instance, if Treasury bills have a rate of return of 3% and a portfolio provides a rate of return of 10%, then 7% is the excess gain. These ratios act as critical decision-making tools, providing an understanding of how different portfolios or securities fare. Virtually every investment decision in the financial market is preceded by ratio analysis. Interpreting metrics in tandem with objectives is a crucial practice for all market participants. That’s because such ratios offer key insights into different aspects of an investment, primarily how profitable it will be. Moreover, the ratio represents the excess returns above the risk-free rate, meaning a higher ratio is preferred because it suggests greater returns on the portfolio, with the opposite being true for a lower ratio.

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It also takes into account the average portfolio/investment market return and the beta. Jack Treynor is credited with introducing the Treynor’s ratio that has become a common yardstick to measure the risks taken vis-a-vis the returns generated by a mutual fund scheme. The ratio measures the risk-adjusted returns that a mutual fund scheme earns.

The Treynor Ratio compares the excess return of an investment over the risk-free rate to its systematic risk, as measured by beta. The Treynor Ratio is a measure of a portfolio’s excess return per unit of systematic risk, or the market volatility of the portfolio. Stocks with a higher beta value have more chances to rise and fall more easily than other stocks in the stock market with a relatively lower beta value. So when considering the market, the average comparison of beta values cannot give a fair result.

Application in Mutual Funds

Another popular ratio used in assessing the performance of a mutual fund scheme is the Sharpe ratio, contributed by William Sharpe. The Sharpe ratio measures the overall returns generated by a mutual fund scheme against the different types of investment risks. Treynor’s ratio, on the other hand, measures the returns over the risk-free rate of return, i.e. the returns earned after deducting the risks taken. This formula reflects that the Treynor ratio is concerned with both portfolio return and its systematic risk, and shows excess returns per unit of systematic risk. The higher the Treynor ratio, the better the risk-adjusted return i.e. a higher return per unit of systematic risk and consequently a better performance of the portfolio manager. The Treynor ratio is a powerful tool for assessing how well a portfolio is compensating investors for market risk.

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So here comes the utility of the Treynor ratio because it helps compare investments or stocks with nothing common to get a clear performance analysis. It must be noted here that the direct and linear relationship between higher beta and higher long-term returns might not be as robust as it is believed to be. Academics and investors will invariably argue about the most effective strategies for activity risk for years to come. In truth, there may be no measure to be regarded as the perfect measure of risk. The Treynor Ratio measures how much excess return an investment or portfolio has generated for automated trading each unit of market risk taken.

The risk-free rate typically refers to the yield on government securities, such as Treasury bills. The Treynor Ratio measures the efficiency of a portfolio by comparing its excess returns over the risk-free rate to its beta, which represents the portfolio’s sensitivity to market movements. The Treynor ratio is thought of the best performance measure for a diversified portfolio and is used to analyze and manage the systematic risk. Further, this ratio is helpful vis-à-vis managing investment decisions to improve and optimize portfolio returns.

Mixed Asset

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  • ” While there’s no fixed benchmark, a Treynor Ratio greater than 1 is generally considered good, as it means the portfolio is generating more return than the risk being taken.
  • Adjustments for management fees and transaction costs ensure the calculation accurately represents net returns.
  • The Treynor Ratio measures portfolio performance and is part of the Capital Asset Pricing Model.
  • A portfolio with a high number of volatile stocks will have a beta value greater than 1.

In fact, it is less volatile than the market benchmark is normally given a beta value of 1. But it turned out to offer the best return per unit risk taken as shown by the Treynor Ratio. From the perspective of an investor, the insights derived from comparing the risk-adjusted fund returns contributes toward the selection of which funds to allocate their capital to. A higher Treynor ratio is preferable because it denotes higher returns for each unit of risk.

So, for the same quantum of risk, the second fund offers a higher return potential and is, therefore, a better alternative. Treynor ratio and Sharpe ratio are, therefore, two different ratios, each of which gives an insight into a mutual fund’s return generating potential against the inherent risks. The Fixed Income portfolio has a higher Treynor ratio, which suggests that this portfolio has a more favorable risk/return mix than the fixed income portfolio. Therefore, it is advisable for an investor to invest in the Fixed Income portfolio. It’s important to note that the Treynor ratio does not provide meaningful values for negative values of beta. Further, though the Treynor ratio can be used to rank investment portfolios, it does not provide information on whether these investment portfolios are superior or better than the market portfolio.

So, what you have to do is subtract the anticipated portfolio return (as Best monthly dividends calculated by the CAPM) from the actual return. This value indicates the excess return over what was anticipated, given the risk level. The first one has a Treynor ratio of 2 while the second one has a ratio of 3. This would mean that in the first fund if you undertake a risk of 1%, you stand to earn a return of 2%. On the other hand, in the second fund, if you take the risk of 1%, you stand to earn a return of 3%.

  • However, such a portfolio has to assume some degree of systematic risk to achieve additional returns.
  • The Treynor Ratio is one way investors assess whether a portfolio or fund delivered enough return for the risk taken.
  • He introduced the measure in the 1960s as part of his research on capital asset pricing models.
  • For example, if a stock has been giving the firm a 12% rate of return for the past several years, it is not guaranteed that it will go on doing the same thing in the years to follow.
  • The higher the Treynor ratio, the better the risk-adjusted return i.e. a higher return per unit of systematic risk and consequently a better performance of the portfolio manager.

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Thus, it isolates the risk factor and provides investors with a better understanding of the gains they can earn by undertaking the same. The Treynor Ratio is a risk-adjusted performance measure that indicates how much return an investment earned per unit of risk taken. It adjusts for systematic risk, offering insights into the efficiency of an investment on a risk-adjusted basis. In the stock market, the broad market index, such as the S&P 500, is given a beta of 1.

A higher Treynor ratio indicates a more favourable return on risk taken, suggesting better risk-adjusted performance. You can use the Treynor’s ratio to compare between various mutual fund schemes and then shortlist suitable ones for investment. A high Treynor’s ratio is a favourable indicator as it shows that for each unit of risk that you undertake, you would earn a higher unit of return. Strategic asset allocation involves setting target allocations for various asset classes based on the investor’s risk tolerance, time horizon, and financial objectives. This long-term approach aims to create a diversified portfolio that can weather different market conditions. Some portfolio managers and analysts prefer the Treynor ratio over plus500 canada the Sharpe ratio, when they are looking at diversified portfolios.

Moreover, the accuracy of TR depends on whether one applies an appropriate index in its calculation. If one were to use the Nifty 50 to determine the TR of a portfolio consisting mainly of small and mid-cap stocks, then it would not work. So, the market index yielded a better risk-adjusted return during that period.