Treynor Ratio

As an investor you must have often read that one of the advantages of a mutual fund is diversification of risk. This makes one feel that mutual fund is a less risky proposition than investing in stocks. But the fact of the matter is that mutual funds are also risky, and even well diversified funds carry risk.

Risks are broadly classified into two categories—company risk and market risk. When you invest in a company, you could lose money because that company doesn't do well due to reasons internal to it. Or, you could lose money because the general economic climate worsens and all companies do badly. To illustrate, suppose you have invested in the automobile sector by investing in TELCO.

Now if TELCO's cars and trucks do not sell well you are going to lose money. Had you also invested in, say, Ashok Leyland, you may have lost less money. However, if the economy is doing badly and no one is buying cars and trucks, then no matter how well you had diversified, you would still have lost money. The first kind of risk is company risk and the second type of risk (represented by Beta), is known as market risk.

Clearly, diversification can only be a useful defence against company risk, and not against market risk. No matter how diversified the portfolio of the mutual fund is, this risk cannot be ignored. Hence this risk must be compensated by some reward. Why is this so? Because the investor has an option to hold a liquid asset like treasury bills that provide a return which is known with certainty in advance. With the choice of a risk-free asset always available to them, investors will buy riskier assets only if they can expect a return greater than the risk-free return.

The Treynor Ratio, named after Jack L. Treynor, one of the fathers of modern portfolio theory, helps analyse returns in relation to the market risk of the fund. The Ratio, also known as the reward-to-volatility ratio, provides a measure of performance adjusted for market risk. Higher the Treynor Ratio, the better the performance under analysis.

It is similar to the Sharpe Ratio, except that it uses Beta as the volatility measurement. The ratio divides the difference of the average return of a fund and the risk free rate by beta (market risk) of the fund. Therefore it tells us the return over the risk free per unit of market risk. Sharpe Ratio divide the same difference by the fund's standard deviation.

For instance, if the fund's average return is 10 per cent and the risk free rate is 7 per cent, the difference becomes 3 per cent. If the historic beta of the fund is 1.5, then the Treynor Ratio is 2 (3 divided by 1.5). This means that in past, the fund has given two units of return for one unit of its market risk.

When is such an indicator useful? In case of well-diversified portfolios, total risk is a more meaningful measure of risk. While for non-diversified portfolios, market risk becomes a relevant measure of risk. This is because for a well-diversified portfolio, the company risk will be low, ie the total risk should be close to market risk. In this case the Sharpe and Treynor ratios will rank such funds in same order. But for non-diversified portfolios, the two ratios can give different rankings.

Hence, the Treynor Ratio offers another risk adjusted performance measure bringing focus to that element of risk, which is unavoidable. This tries to convey that by investing in another fund you are adding the market risk to your overall portfolio of assets, for which you must be compensated. The ratio thus becomes meaningful if you have investments in more than one fund, but it is of less relevance if you intend to own a single fund.