Investors have all sorts of tools for measuring how they are doing and whether a potential acquisition is likely to pay enough to justify the risk. The most common measures are those that relate figures like earnings or book value to share price. Then there are gauges like beta, Sharpe ratio, Sortino ratio and even something called the upside and downside capture ratio.
And then there’s Treynor ratio, offered to investors who probe the fund analysis pages of market data firms. But while all gauges can provide useful insight, many experts caution that small investors should stick to tried-and-true practices like setting an appropriate asset allocation and standing firm in downturns rather than jumping from fund to fund to pursue the best risk and reward numbers.
Treynor ratio is used to determine whether a portfolio is doing well enough to justify the risk, says Matt Ahrens, advisor with Integrity Advisory in Overland Park, Kansas.
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“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, then I look at the Treynor ratio to see how much return am I getting per unit of risk,” he says. “Basically, am I getting bang for my buck?”
Beta, familiar to many investors, shows how widely a fund’s performance varies from an underlying benchmark like the Standard & Poor’s 500 index. Wide swings mean that in any given period, the fund could do significantly better or worse than the benchmark — whether it’s riskier, in other words.
Treynor ratio takes it a step further. Sometimes called the reward-to-volatility ratio, it considers not just beta but the return that could be earned on a risk-free holding like a U.S. Treasury bond. The risk-free return is subtracted from the portfolio’s expected return, and the result is divided by the portfolio’s beta. The higher the result, the better the return relative to the risk.
At first glance, Treynor ratio looks about the same as Sharpe ratio, which might be more familiar to many investors. Sharpe ratio also measures return relative to risk, and similarly the risk-free return is subtracted from the portfolio’s expected return. But instead of dividing the result by beta, it divides by standard deviation, which is how much a portfolio’s return can vary from its average return. By using beta, Treynor ratio relies on an outside benchmark for variation. Many experts say Sharpe is best for gauging an entire portfolio, Treynor for looking at individual funds in the portfolio.
For many investors, these nuts and bolts of performance gauges is a bit much, and sophisticated portfolio gauges can be like high-powered weapons best handled by trained users. A good performance statistic doesn’t necessarily mean a given fund is suitable for a given investor.
“The trap do-it-yourselfers fall into is being unable to decipher where outperformance is coming from,” Ahrens says. “A manager may be performing well versus their peers just because they are taking on more market risk.”
Another misuse would assume a high Treynor ratio means the fund is good, says S. Michael Sury, lecturer in finance at the University of Texas at Austin. The ratio is not an absolute measure of fund quality but a way of comparing one fund to others, he says.
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“Treynor ratio does have some drawbacks,” he adds. “Importantly, by definition, it is a backward-looking ratio. Thus, it tends to be more useful for its evaluative — rather than its predictive — power.”
Risk measures like beta are also imperfect, he says, since volatility is not really the same as what investors worry about most — the permanent loss of money. But risk-and-reward gauges rely on volatility measures because they exist, while data on permanent loss does not.
Michael B. Miller, CEO of Northstar Risk, a firm that analyses risk and performance for hedge funds, is not a big fan of Treynor ratio but says investors are wise to understand it nonetheless.
“The ratio is motivated by two important concepts,” he says. “First, you should care about risk-adjusted returns not absolute returns. 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.”
Finally, Paul Ruedi of Ruedi Wealth Management in Champaign Illinois, warns small investors not to get too focused on performance gauges of any type.
“Nobody goes into the grocery store with their Treynor ratio return, they go into the grocery store with their actual return,” he says.
“At the end of the day, over 90 percent of an investor’s lifetime return is a result of two things. The first is their allocation to equities versus fixed-income. And second to that, but probably just as important — or maybe even more important — how they behave when the portion of their portfolio that is invested in the great companies of the U.S. and the world is temporarily down 30 percent or 50 percent.”
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In other words, sticking with your holdings through thick and thin will probably be a better strategy than jumping from fund to fund as performance numbers change.
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Is the Treynor Ratio for You and Your Money? originally appeared on usnews.com
