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How to Use the Treynor Ratio to Invest in Mutual Funds

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How to Use the Treynor Ratio to Invest in Mutual Funds How to Use the Treynor Ratio to Invest in Mutual Funds Investing in Mutual Funds There are many ratios to measure a stock’s performance. That is especially true with mutual funds. The COVID-19 crisis caused the current bear market. With that uncertainty, traders want to use the most precise formulas to determine the best mutual funds for investment. The Treynor Ratio is one formula that can measure a mutual fund’s performance. This TradingSim article will provide an overview of the ratio and then explain how investors can use the ratio to measure the top 10 mutual funds. What is the Treynor Ratio? The Treynor Ratio is a reward-to-volatility formula. The ratio measures an investment’s performance per unit of risk. In the Treynor formula, beta is measured in risk. Beta is the measure of a stock’s volatility in relation to a benchmark like the S&P 500. The ratio calculates beta and the returns on risk-free returns. With the Treynor formula, The S&P 500 usually has a beta of one. Stable stocks have a beta below one. Volatile stocks have a beta over one. In the Treynor Ratio, the formula is: (Ri-Rf)/B, where: Ri=return of investment Rf= risk-free rate. That’s typically the yield on short-term Treasury bills. B-= the beta of the portfolio. Beta is considered to be measured against a key benchmark. It’s measured with the return that could be earned on a risk- free asset like the Treasury bill in the reward-to-volatility ratio. The risk-free rate is subtracted from the portfolio’s return of investment. The result of that equation is divided by the portfolio’s beta. A higher Traynor ratio means that there is a better return. The S&P 500 and the Dow Jones 30, since 1970s What do the numbers in a Treynor ratio mean? A high Treynor Ratio means an investment has added value related to its risk. In addition to that result, a negative Treynor Ratio means the mutual fund performed worse than a risk-free asset. Who created the Treynor Ratio? Jack Treynor was the economist who created the method. He was one of the first economists to discover the capital asset pricing model (CAPM). That CAPM model codified investment return risks that became the basis for the Treynor Ratio. How can investors use the Treynor formula? Matt Ahren is a financial advisor with Integrity Advisory in Overland Park, Kansas. He notes how the Treynor Ratio is used to justify risks in investments. “I manage the portfolios for our firm, so if I am reviewing an individual fund then I first look at the fund’s beta to see how much market risk that manager is taking,” said Ahrens. Aherns inspects a mutual fund’s Treynor formula to see if a portfolio’s performance justifies its risk. “Then I look at the Treynor ratio to see how much return am I getting per unit of risk. Basically, am I getting bang for my buck?” said Aherns. What is the Treynor Ratio’s legacy? Robert Merton knew Treynor well. He is a Nobel Prize-winning economist at the Massachusetts Institute of Technology. Merton credits Treynor with bringing more mathematical analysis to finance. “It wasn’t that he just did a particular theory,” he said. “He was very creative and also was a leader in bringing the quantitative finance science to finance practice. That was his bridge.” Bruce I. Jacobs is a principal of Jacob Levy Equity Management. He also credits Treynor for bringing mathematical formulas to better analyze stocks and mutual funds. “Jack had incredible insights about the markets and models and helped bring quantitative finance into practical application,” said Jacobs. How Treynor Ratio is vital to analyzing risk MIT finance professor Andrew Lo also praised the Treynor Ratio and CAPM. He also credits the Treynor Ratio with acknowledging the importance of beta when analyzing a stock. “In part, it acknowledges that there’s a trade-off between risk and return and CAPM quantified what the trade-off is. That relationship is what gave rise to the notion of beta,” said Lo. In addition, Lo also noted that the beta of a mutual fund can be crucial to measuring a mutual fund’s risk. “So, when we talk about the beta of a stock, that comes out of that framework. When we do discounted cash flow analysis, we’re using some kind of cost of capital. CAPM is the tool we use to calculate that cost of capital,” added Lo. Treynor Ratio builds on work of Sharpe Ratio The Treynor formula builds on the work of fellow economist William Sharpe. Lo noted that the capital asset pricing model championed by economists is vital to the mutual fund industry. “CAPM is also the basis of the mutual-fund industry, particularly for passive investing. You ought to just buy and hold the market, and you’ll do just fine,” said Lo. “Vanguard[ a large mutual fund corporation] and all of the index funds out there came about because of the contributions of Sharpe, Treynor, and others made in finding the capital asset price model. The multi-trillion-dollar passive-index business — we can thank Sharpe and Treynor for that wonderful gift,” added Lo. Michael B. Miller, CEO of Northstar Risk, also noted the importance of the Treynor Ratio in evaluating the performance of mutual fund portfolios. While he’s critical of the method, he still praises the Treynor ratio as effective. “The ratio is motivated by two important concepts First, you should care about risk-adjusted returns, not absolute returns,” said Miller. “Second, in a well-diversified portfolio, you should worry more about the macroeconomic factors that could impact your portfolio and less about the risk from individual securities,” added Miller. What is the difference between the Sharpe ratio and Treynor Ratio? The Treynor formula builds on a previous measurement of the Sharpe Ratio. Both formulas can be beneficial to an investor to assess mutual fund investments. William Sharpe created the formula to help investors understand the risk of an investment in relation to its return. The Sharpe Ratio is similar to the Traynor Ratio because they both assess risks of portfolios. While both formulas have similarities, there are differences between the two ratios. The Treynor Ratio assesses a systemic risk of a portfolio against a benchmark like the S&P 500. However, the Sharpe Ratio measures the performance of a portfolio based on the overall total risk of a portfolio. William Sharpe creator of Sharpe ratio, a counter to Treynor Ratio What is the Sharpe Ratio formula? The Sharpe Ratio equation is: (Rp – Rf)/σ , where: Rp= return on portfolio Rf= risk-free rate σ =standard deviation on the return of the portfolio The Sharpe Ratio subtracts the risk-free rate of return from a portfolio’s return. The result is divided by the investment’s return’s standard deviation. A standard deviation measures the investment risk in a mutual fund. It’s applied to an investment’s annual rate of return to calculate risk. The higher the Sharpe ratio, the better for a mutual fund. A Sharpe Ratio of 1 and over is considered good for a mutual fund. A negative Sharpe Ratio means the expected return may be negative. The negative quotient could also mean that the portfolio’s return is worse than the risk-free rate. Which is better to measure mutual funds, the Sharpe Ratio or Treynor Ratio? Both formulas can effectively measure the performance of a mutual fund. However, there are two differences between the measurements. The Sharpe Ratio can be applied to all portfolios that are in specific sectors. In specific sectors, specific mutual funds may have unsystematic risk as to the best measure of risk. In that case, the Sharpe Ratio may be the better formula because it measures overall risk. However, with the Treynor Ratio, there is a difference. The Treynor Ratio measures systematic risk. Unsystematic risk is not a factor with diversified mutual funds. Because of that, the Treynor Ratio can measure systematic risk. The Treynor Ratio can be a better metric to evaluate the performance of a well-diversified mutual fund portfolio. What are the downsides to the Treynor ratio? While the Treynor Ratio can be an effective measure of a portfolio’s performance, it’s not perfect. Some financial experts say that the metric has a downside. S. Michael Sury is a lecturer in finance at the University of Texas at Austin and studies the Treynor index. He noted that the Treynor formula isn’t perfect. Sury because it only looks at past performance. “Treynor ratio does have some drawbacks. Importantly, by definition, it is a backward-looking ratio. Thus, it tends to be more useful for its evaluative – rather than its predictive – power,” said Sury. Some financial experts like Aherns believe that a mathematical analysis may not be the best way to analyze stocks for beginning traders. “The trap do-it-yourselfers fall into is being unable to decipher where outperformance is coming from,” said Ahrens. In addition, Aherns also noted that taking on more risk may benefit them more than using the Treynor formula to calculate risk. “A manager may be performing well versus their peers just because they are taking on more market risk,” said Ahern. Is the Treynor Ratio helpful to investors? While many financial advisors use the Treynor Ratio, there are financial managers that aren’t fans of the formula. Paul Ruedi of Ruedi Wealth Management doesn’t believe that the Treynor formula is best for the average investor.
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