When investing in a mutual fund scheme, a little bit of research into the scheme performance is recommended. This helps you pick out the best scheme that offers attractive returns and has quality portfolio management.
Various parameters help in assessing a mutual fund scheme. Treynor’s ratio is one such parameter that can give useful insights into a mutual fund scheme. Let’s understand what the ratio is all about.
This article covers:
What is Treynor’s ratio?
Jack Treynor is credited with introducing the Treynor’s ratio that has become a common yardstick to measure the risks taken vis-a-vis the returns generated by a mutual fund scheme. The ratio measures the risk-adjusted returns that a mutual fund scheme earns. In other words, at a given level of market risk, the returns of the fund that exceed the risk-free return are denoted by Treynor’s ratio.
Understanding Treynor’s ratio
When you invest in a mutual fund scheme, you are exposing your investment to two main types of risks. These risks are as follows:
- Company risk: The risk of a company performing badly due to internal problems and mismanagement.
- Market risk: The risk of the overall market suffering a downturn due to unavoidable economic factors.
You bear these risks when you invest in mutual fund schemes and the returns that you earn for bearing these risks are measured by the Treynor’s ratio.
Treynor ratio and Sharpe ratio
Another popular ratio used in assessing the performance of a mutual fund scheme is the Sharpe ratio, contributed by William Sharpe. The Sharpe ratio measures the overall returns generated by a mutual fund scheme against the different types of investment risks. Treynor’s ratio, on the other hand, measures the returns over the risk-free rate of return, i.e. the returns earned after deducting the risks taken.
Treynor ratio and Sharpe ratio are, therefore, two different ratios, each of which gives an insight into a mutual fund’s return generating potential against the inherent risks.
Treynor ratio formula
A specified Treynor ratio formula is used to calculate the ratio. This formula is as follows:
Treynor’s ratio = (Rp – Rf) / B
In the formula:
Rp is the return generated by the mutual fund scheme or portfolio
Rf is the risk-free rate of return
B is the Beta coefficient
For example, say the risk-free rate of return is 8% and the fund generates a return of 12%. The beta coefficient is 2. Using the Treynor ratio formula, the ratio would be calculated as follows:
Treynor’s ratio = (12% – 8%)/2 = 2
This means that for each unit of risk that you bear, you earn 2 units of returns.
A word about the beta coefficient
The beta of a mutual fund scheme measures the sensitivity of the returns of the fund to the movement of the benchmark of the fund. Here’s how it is read:
- If the beta coefficient is 1 it means that the fund changes in sync with the benchmark. So, if the benchmark increases by 1%, the fund’s returns would also increase by 1% and vice-versa.
- A beta of more than +1 means that the fund is more sensitive to the change in the benchmark rate. If the benchmark increases by 1%, the fund’s returns would increase by more than 1% and vice-versa. A high beta indicates high volatility and the potential for high returns.
- A beta of less than +1 would mean that the returns are not very sensitive to the change in benchmark rates. If the benchmark rate increases by 1%, the fund’s returns would increase by less than 1% and vice-versa.
- A beta of -1 means that the fund moves opposite to the movement of the benchmark. If the benchmark rate increases by 1%, the fund’s returns would reduce by 1% and vice-versa.
Application of Treynor’s ratio
You can use the Treynor’s ratio to compare between various mutual fund schemes and then shortlist suitable ones for investment. A high Treynor’s ratio is a favourable indicator as it shows that for each unit of risk that you undertake, you would earn a higher unit of return.
For example, say there are two mutual fund schemes. The first one has a Treynor ratio of 2 while the second one has a ratio of 3. This would mean that in the first fund if you undertake a risk of 1%, you stand to earn a return of 2%. On the other hand, in the second fund, if you take the risk of 1%, you stand to earn a return of 3%. So, for the same quantum of risk, the second fund offers a higher return potential and is, therefore, a better alternative.
Moreover, when you compare the Sharpe ratio and Treynor ratio, the latter would give a better understanding of the risk-adjusted returns that you can earn from a mutual fund scheme.
Limitations of Treynor’s ratio
There are a few limitations of the ratio that you should know about. These limitations include the following:
- Treynor’s ratio is calculated based on historical data. As such, the ratio presents historical information about the mutual fund scheme. This information might, therefore, not be relevant for the present-day investment decisions as there are no guarantees on the behaviour of the fund in present as well as in future. If the fund management style changes, the ratio would lose its meaning.
- The ratio does not guarantee the performance of the mutual fund scheme in future. The returns are dependent on macroeconomic factors and if such factors change, the returns might also change. In such cases, you might not make as much profit for every unit of risk that you undertake as depicted by the Treynor ratio.
- The ratio does not provide meaningful and relevant values if the beta coefficient of the fund is negative.
- When comparing mutual funds, a high ratio is favourable but it does not guarantee the same proportionate increase in the return generating potential of the scheme. For example, if two funds have Treynor’s ratios of 2 and 4 respectively, it does not mean that the second fund would offer twice as much return as the first fund.
Treynor’s ratio can prove to be instrumental when comparing mutual fund schemes. So, understand what the ratio means, how it is calculated and how you can use it for comparison. Also, keep in mind the limitations of the ratio and compare mutual funds on other parameters, including the Treynor ratio, to make the right choice when investing.