Treynor Ratio

This is another risk-adjusted performance measure, similar in calculation and application to the Sharpe ratio. The difference is that while Sharpe weighs a fund’s returns against total risk (standard deviation, or volatility), Treynor looks at excess return for each unit of systemic risk (the volatility, inherent in the market that cannot be diversified).

The Treynor calculation takes the fund’s excess return over a notional risk-free rate, then divides it by the fund’s beta. A Treynor ratio greater than 1 shows that the fund has produced more units of return than of risk. Based on market risk alone, the ratio assumes that nonsystemic risk is capable of being eliminated by diversification across a wide range of investments, and it measures whether the systemic risk has been rewarded.

Also known as the volatility-to-reward ratio, Treynor is useful in comparing funds that invest in similar market sectors and achieve similar returns. For example, when assessing a range of UK equity funds, it is the one with the highest Treynor ratio that is taking on the least market risk to achieve its level of performance. Also, since it factors out the manager’s ability from movements in the fund’s sector, Treynor may be used to compare fund performances adjusted for systemic risks in different market sectors because, although intuitively the ratio should be higher for bond funds than for those investing entirely in equities, this is not necessarily true in every case. While not perfect, and not to be taken in isolation, the Treynor ratio can be a pointer to the optimum risk- and sector-adjusted fund for a particular risk-aversion profile.