Treynor Ratio Calculator
With this Treynor ratio calculator, you can easily analyze your portfolio's performance against systematic risk. The Treynor ratio is commonly used to analyze a portfolio's investment performance. Most importantly, it tells us how much return you are getting per unit of systematic risk you are taking.
We have prepared this article to help you understand what Treynor ratio is and how to calculate it using the Treynor ratio formula. By demonstrating some Treynor ratio examples, we aim to instill you with the concept. Now, let's start by discussing the fundamentals.
What is the Treynor ratio? — The Treynor measure meaning
The Treynor ratio, or Treynor measure, is a widely used performance metric that measures how much a portfolio returns are above the risk-free rate by taking on an extra unit of systematic risk. In essence, the Treynor ratio helps you to analyze if the risk you are taking on is rightly compensated.
Unlike the Sharpe ratio, which uses the total risk as the denominator, the Treynor ratio uses the systematic risk. When we compare the Treynor ratio vs. Sharpe ratio, the former is usually considered to be the more fair variant. This is because, according to the efficient market theory, investors will only be compensated by taking on more systematic risk.
Next, let's look at some examples to understand how to calculate the Treynor ratio.
How to calculate the Treynor ratio? — Treynor ratio formula
Taking Company Alpha as the Treynor ratio example, which reports the following information, let's talk about how we should use the Treynor ratio formula:
- Beginning portfolio value: $2,000,000
- Ending portfolio value: $2,200,000
- Portfolio beta: 1.25
- Risk-free rate: 1.5%
- Determine your portfolio return.
We need to first calcualte the
portfolio returnusing the formula below:
portfolio return = (ending portfolio value - beginning portfolio value) / beginning portfolio value
For our example,
($2,200,000 - $2,000,000) / $2,000,000 = 10%.
- Determine the risk-free rate.
As for the
risk-free rate, we can safely assume it to be equivalent to the yield of a 10-year US government bond. This is because the 10-year US government bond has almost no credit risk. If you want to look for this information, visit the website.
In our example, we will assume the
- Determine the portfolio beta.
To calculate the
portfolio beta, we need to calculate the weighted average from the beta of the portfolio's holdings. For this portfolio, the
- Calculate the Treynor measure using the Treynor ratio formula.
Finally, we can use the
Treynor ratioformula to calculate the
Treynor ratio = (portfolio return - risk-free rate) / portfolio beta
Treynor ratiofor the Company Alpha portfolio is:
(10% - 1.5%) / 1.25 = 6.8%.
Why is it essential to understand the Treynor ratio?
Since we now have an understanding of what the Treynor ratio is and its calculation, we can now talk about how to interpret what is a good Treynor ratio.
The Treynor ratio is mainly used to measure the amount of return you are getting by taking on an extra unit of systematic risk. It is vital to understand the importance of measuring your return against the systematic risk, which is represented by the portfolio's beta, instead of the standard deviation, which is the total risk.
Total risk is equivalent to the sum of the systematic risk and the unsystematic risk. As unsystematic risk is the risk that can be diversified away, according to the efficient market theory, investors should not expect to be compensated by taking on more unsystematic risk. That's why the Treynor ratio is often considered to be theoretically more accurate.
However, there are a few limitations that you should keep in mind when using the metric. Firstly, it is a backward-looking metric. Its reliability is hence heavily dependent on the accuracy of the historical data. Moreover, the difference between Treynor ratios has little meaning. Although we can rank the Treynor ratios, as the higher Treynor ratios are generally better, we cannot say that a Treynor ratio of 5 is 2 times better than a Treynor ratio of 2.5.
What is a good Treynor ratio?
Speaking in general, the higher the Treynor ratio the better, as it means you are earning more return for each unit of systematic risk you take. However, it is crucial to keep in mind that the difference between Treynor ratios has little meaning. A Treynor ratio of 3 does not necessarily mean it is 3 times better than a Treynor ratio of 1.
Can Treynor ratio be negative?
Mathematically speaking, the Treynor ratio can be negative. In reality, though, it is highly unlikely, as that means the return of your portfolio is lower than the risk-free rate.
What is the difference between the Treynor ratio and Sharpe ratio?
Sharpe ratio measures the return of your portfolio against the total risk, whereas the Treynor ratio uses systematic risk. From the comparison Treynor ratio vs. Sharpe ratio, the former is generally considered more accurate as investors are normally only compensated by taking on more systematic risk.
What is the risk-free rate?
The risk-free rate is the annual rate of return of an investment that has practically zero risks involved. The 10-year and 20-year US Treasury yields have typically been used as the proxies for the risk-free rate.