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Treynor Ratio measures the efficiency with which the fund manager has allocated the fund’s assets to compensate the investor for taking the given level of risk.
Treynor ratio is a measure of the returns earned more than the risk-free return at a given level of market risk. It highlights the risk-adjusted profits generated by a mutual fund scheme. This ratio was given by Jack Treynor, thereby expanding the contribution of William Sharpe towards modern portfolio theory. The Sharpe Ratio provides an overview of the return generating capacity of the fund against the overall risk. However, the Treynor Ratio exclusively focuses on how well the portfolio has performed in the backdrop of risks prevailing in the economy.
To make things lucid, you need to know that returns of an investment portfolio are vulnerable to two types of risk, i.e. company risk and market risk. If your portfolio returns fall on account of one firm in the segment, it is because of internal adverse factors faced by the firm. You may perceive it as a company-related risk.
On the other hand, if the portfolio returns are affected due to bad performance of firms, then the reason might be an overall economic downturn. You may perceive it as market risk. You are advised to maintain a diversified portfolio to eliminate the chances of losing money owing to company risk. However, market risks cannot be excluded. Hence, when you take that risk while investing in a mutual fund scheme, you become eligible to receive a reward called the risk premium. The higher the risk taken, the higher is the reward.
Thus, the Treynor Ratio of a mutual fund indicates how well you will be rewarded for taking the risk of investing in a particular mutual fund scheme.
Treynor Ratio gauges how efficiently the fund manager achieves the balance between return and risk of the portfolio. Unlike Sharpe Ratio, it makes use of beta in the denominator. You need to know that beta indicates the sensitivity of fund returns to movements of the underlying benchmark.
The beta of a fund which invests in highly volatile stocks would be higher than the fund which invests in less volatile securities. Stocks having high volatility rise and fall faster during a market rally and slump respectively. The higher the beta, the higher is the sensitivity of fund returns and riskier is the investment.
Thus, as compared to low-beta stocks, the stocks with high beta might generate higher or lower returns based on the market performance. In other words, the Treynor Ratio takes into account market risk while calculating risk-adjusted returns. The Treynor ratio can be calculated by using the following formula:
Suppose the average return generated by your fund is 10% and the risk-free rate is 6%. The difference between the fund return and the risk-free rate becomes 4%. If the fund’s historical beta is 2, then the Treynor Ratio will be 2 (i.e. 4 divided by 2). It implies that the fund gave two units of return for every additional unit of market risk assumed.
While comparing two funds, you may use Treynor Ratio to arrive at the ideal fund. It is assumed that the fund with a higher Treynor ratio is better at compensating you for risk-taking as compared to the other fund, which has a lower Treynor Ratio.
The investors use Treynor Ratio as a simple tool to measure the risk-adjusted return earning potential of a portfolio. However, as an investor, you need to know that it also suffers from several limitations.
Treynor Ratio might be an excellent way to analyse and identify the superior performing investment among a group of funds. But it is valid only when the given investment is a subset of the broader portfolio. Instances where the portfolios have similar systematic risks but total variable risk, then the Treynor Ratio will provide them with the same rank even though it is not valid.
Treynor Ratio is calculated based on the historical data. You, thereby, get to know about the behaviour of the portfolios in the past. However, there’s no guarantee that the portfolio will continue to behave in the same manner in the future. As the market dynamics change, the portfolio might become more or less vulnerable depending upon the volatility of the underlying securities.
Thus, the Treynor Ratio cannot become a mirror to reflect the future potential of a portfolio. You might have to use it in combination with other ratios to arrive at an accurate decision. Consider a portfolio which has delivered an average return of around 12% for the past five years and has a beta of 1.5. But there is no guarantee that the portfolio will continue to perform in the same way in the years to come. The rate of return may go up or down, depending on the macroeconomic factors.
Treynor Ratio may come handy in shortlisting appropriate mutual funds before arriving at the final decision. Usually, a fund which has a higher Treynor ratio is regarded as superior as compared to the one with a lower Treynor Ratio.
However, it would be best if you used the ratio based on the characteristics of the portfolio. If you consider a well-diversified portfolio, the company risk will be low, which means that the total risk would be almost equal to market risk. In such a scenario, the Sharpe and Treynor Ratios would yield similar results, i.e. they will rank such funds in the same order. However, in the case of non-diversified portfolios, market risk tends to be the better risk measure.
Hence, in this situation, the ranks given by the two ratios will be different. Hence, the Treynor Ratio gives additional risk-adjusted performance metric by considering the non-diversifiable element of risk.
If you find that the addition of a new fund lowers the Treynor Ratio of the portfolio; it means that the new fund only increased the riskiness of the portfolio without contributing to the overall portfolio returns. Thus, you may relook at your decision of adding the new fund to the portfolio.
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