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Treynor Ratio

 

Treynor ratio is another popular ratio that is used to measure the performance of investment portfolio. This ratio compares the excess return (above risk free return) of a portfolio to beta of that portfolio. While beta is a measure of risk (volatility), this ratio compares the return of a portfolio to its risk. 

 

The higher ratio means the better performance of a portfolio manager. However, if the manager of the fund had been changed, then performance of the fund is also expected to change and the data of the past does not mean anything anymore. 

 

Treynor ratio formula


Treynor ratio = (Return of portfolio - Risk free rate) / Beta of the portfolio

 

* When this ratio is calculated, return of a portfolio is calculated as average of annual returns during the period; risk free rate average is determined in the same way. 

 

Main Problems of Treynor Ratio in Practice

The main problem in practical application of this ratio is beta determination. It is very difficult to select a proper benchmark (which represents market risk) for the portfolio which is needed to calculate beta. Right benchmark index should exactly meet the risk level of the portfolio while that can be very difficult when portfolio includes investments from different markets and sectors

 

If benchmark index that is used in beta determination won’t be very accurate, then longer period of data should be included when calculation Treynor ratio. To be trustworthy in such case (when benchmark may be not very accurate) ratio should include data of at least one full economical cycle. Long period should also be used if portfolios that are compared consist of different asset classes.

 

Another problem is relevant to all performance ratios: the portfolio’s performance of the past does not have much in common to the performance in future periods. 

 

Other ratios to measure investment performance






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