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Difference Between Sharpe Ratio vs Treynor Ratio in Mutual Funds
Choosing a proper investment strategy is crucial to reaping the returns from it. You must keep track of your investment to get a high return. Several tools can help you track your investment. The Sharpe ratios and Treynor ratios are among those risk measurement tools. Both tools guide you through the risk and help minimise it.
This article clarifies these ratios, highlights the difference between the Sharpe ratio and the Treynor ratio, and helps you determine which fits your evaluation needs.
Table of Contents
What is the Sharpe Ratio in Mutual Funds?
Nobel laureate William F. Sharpe developed the Sharpe Ratio. This measures how well an investment does compared to a risk-free asset. The change reflects the investment's risk. It gives investors a sense of the excess return. The better the performance, the better the risk-adjusted ratio.
Sharpe Ratio is very popular because it's a simple, versatile performance measure. You can apply it to individual stocks or mutual funds. Also, it applies to whole portfolios. However, it assumes the returns follow a normal distribution. This might not hold in real-world markets.
How to Calculate the Sharpe Ratio?
Understanding the Sharpe ratio calculation helps you keep track of your investment effectively. Here is a formula given below to calculate the Sharpe ratio:
Sharpe Ratio = (R(p)-R(f)) / StdDev Rx,
Where,
- R(p) is the return on investment.
- R(f) is the return of a risk-free investment, such as a government bond or bank fixed deposit.
- StdDev Rx is the standard deviation of the investment's returns.
The Sharpe ratio is a simple calculation: take the portfolio's return, subtract the risk-free rate, and then divide that by the portfolio's standard deviation. This move packs in all the risk and gives you a no-BS view of how much return you're getting for your investment.
What is the Treynor Ratio in Mutual Funds?
The Treynor ratio is named after financial economist Jack Treynor, who measured investment returns relative to market risk exposure. It only considers an investment's systematic risk.
The Treynor ratio focuses solely on through beta without regard to certain specified risks. Its applicability is particularly prevalent in diversified portfolios. The Treynor Ratio measures how well a portfolio uses market exposure to produce returns and is ideal for evaluating market-driven performance.
How to Calculate the Treynor Ratio?
Knowing how to calculate the Treynor ratio helps you effectively keep track of your investment against the risk on your own. Here is a formula given below to calculate the Sortino ratio:
Treynor Ratio = Rp - Rf𝜷p
Where,
- Rp = Expected returns from the portfolio or fund
- Rf = Risk-free rate
- 𝜷p = Return rate based on the overall performance of the market.
The Treynor ratio uses the same strategy. However, instead of standard deviation, it uses beta to measure an investment's sensitivity to market fluctuations. Subtract the risk-free rate from the portfolio return and divide it by its beta. This computes only market risk and is best suited for diversified portfolios.
Key Differences Between Sharpe Ratio and Treynor Ratio
Although both metrics are used to measure the risk and return of an investment, understanding their differences is necessary. The table below elaborates the key differences between them:
Limitations of Sharpe Ratio and Treynor Ratio
Knowing about the drawbacks of the Sharpe and Treynor ratios is essential before making the choice. The table below talks about the disadvantages of both ratios:
Sharpe Ratio vs Treynor Ratio - Which One You Can Use?
The Sharpe Ratio and the Treynor Ratio are both popular metrics used for evaluation. It helps analyse the risk-adjusted performance of an investment portfolio. While they both help investors assess returns, they measure risk differently.
1. Risk Measurement
The risk management aspect is essential for the two. The Sharpe ratio measures systematic and unsystematic risks, while the Treynor ratio focuses only on market risk.
2. Risk Tolerance
Investors with broad risk tolerance and who evaluate total risk efficiency should use the Sharpe ratio since it considers all aspects of risk. This implies that the risk tolerance for the Sharpe ratio is relatively high.
3. Investment Strategy
Investors utilising strategies based on market risk exposure would benefit from the information offered by the Treynor ratio. It provides systematic risk-adjusted returns.
Disclaimer: The information provided on this website is for general informational purposes only and should not be construed as financial, investment, or legal advice. While we strive to provide accurate and up-to-date content, we do not guarantee the completeness, reliability, or suitability of the information for your specific needs.
We do not promote or endorse any financial product or service mentioned in these articles. Readers are advised to conduct their own research, consult with financial experts, and make informed decisions based on their unique financial circumstances. Any reliance you place on the information provided here is strictly at your own risk.
FAQs about Sharpe Ratio vs Treynor Ratio
What are the differences between the Sharpe and Treynor ratios when dealing with unsystematic risk?
What would be the conditions whereby the Sharpe ratio gives poorer results than the Treynor ratio?
Can the Sharpe and Treynor ratios provide conflicting opinions on the same portfolio?
How do Sharpe and Treynor ratios perform when evaluating portfolios with non-normal return distributions?
What does using standard deviation instead of beta mean in Sharpe and Treynor ratios?
How does the Sharpe and Treynor ratio explain leverage in a portfolio?
How do the Sharpe ratios and Treynor ratios influence portfolio management strategies?
How would Sharpe and Treynor ratios interact with derivatives or alternative investment portfolios?
How do the Sharpe and Treynor ratios deal with currency risk in the international portfolio?
Do Sharpe and Treynor ratios have a practical use for the portfolio's illiquid or infrequently priced assets?
How might the Sharpe and Treynor ratios' assessments change during market turmoil or financial crises?
How do Sharpe and Treynor ratios help to compare active vs passive fund management performance?
Actively managed funds aim to outperform the market, potentially exhibiting higher volatility. The Sharpe ratio assesses their performance considering total risk.
Meanwhile, the Treynor ratio evaluates returns relative to market risk.
What is a good Sharpe ratio?
How to calculate the Treynor ratio?
The Treynor ratio is calculated by dividing a portfolio's excess return by its beta. The formula for the Treynor ratio is:
Treynor Ratio = (Rp - Rf) ÷ βp
How to calculate the Sharpe ratio?
The Sharpe ratio is calculated by dividing the portfolio's excess return by its standard deviation. The Formula for the Sharpe ratio is:
Sharpe Ratio= (R(p)-R(f))/SD
What do the Sharpe ratio and the Treynor ratio measure?
Other Important Articles about Mutual Funds
Disclaimer
- This is an informative article provided on 'as is' basis for awareness purpose only and not intended as a professional advice. The content of the article is derived from various open sources across the Internet. Digit Life Insurance is not promoting or recommending any aspect in the article or its correctness. Please verify the information and your requirement before taking any decisions.
- All the figures reflected in the article are for illustrative purposes. The premium for Coverage that one buys depends on various factors including customer requirements, eligibility, age, demography, insurance provider, product, coverage amount, term and other factors
- Tax Benefits, if applicable depend on the Tax Regime opted by the individual and the applicable tax provision. Please consult your Tax consultant before making any decision.
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