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Last issue’s Fundamental Focus discussed the Sharpe ratio, a measure of return adjusted for risk. The Treynor ratio is another risk-adjusted performance figure that is very similar to the Sharpe ratio. Both ratios measure how well an investment vehicle compensates the investor for a given level of risk. Both measure excess return above the risk-free rate per unit of risk. The main difference is that the Sharpe ratio uses standard deviation as the risk measure, whereas the Treynor ratio uses beta.
In this installment of Fundamental Focus, we discuss using and interpreting the Treynor ratio. Stocks that exhibit additional volatility, or risk, should compensate investors with additional long-term returns. Jack Treynor had this relationship in mind when he established the formula that became known as the Treynor ratio. Using an investment’s historical average return allows you to calculate the historical Treynor ratio over a time frame that you choose. Alternatively, you may use the expected average return to calculate the expected Treynor ratio. Of course, using expected average returns may not be accurate since predictions are used. In essence, this return compensates investors for the time value of money.
Inflation dictates that money in the future will not purchase as much as it does now, and the risk-free rate compensates investors for the time that their capital is tied up. Typically, Treasury rates are used as measures of risk-free rates. It is generally good practice to match the duration of the Treasury holding to the length of time of the average return. Alternatively, there are arguments made that since equities are indefinite investment vehicles, the longest-term Treasury should be used. Whatever you choose to use as the risk-free rate is not as important as staying consistent throughout your calculations.
However, it is important that you choose a reasonable risk-free rate. The concept of beta can be more easily described through examples. For instance, if a stock has a beta of 2. 00, it is twice as volatile as the benchmark to which it is compared. Needless to say, the opposite is also true. Interestingly, betas have no upper or lower limit. The figure can be very high for highly volatile stocks.