Sharpe vs Treynor Ratio: Which Do Investors Trust More?

During the market turbulence situation, the wild swings in the market has made many investors worried if they will get enough returns for the risk they are taking. When the market fluctuates, it's not just about how much return you get but also whether the return you get justifies the risk you have taken. That’s where the Sharpe and Treynor ratios come into play. Important financial metrics that help investors determine if their portfolio is performing well compared to its risk taken. However, both have different approaches to determining that.

In this article, we will understand both ratios along with formulas, differences of the Sharpe ratio vs Treynor ratio, and which ratio investors can rely on for their portfolio analysis. Let us start with the Sharpe ratio first.

What is the Sharpe ratio?

A financial metric called the Sharpe Ratio, often known as the Sharpe Index, measures a portfolio's risk-adjusted performance. Investors can use it to know how much return they will receive over the returns from low-risk investments like government bonds and fixed deposits for each unit of risk taken. 

Higher Sharpe ratios (above 1.0, 2.0, and 3.0) are considered favourable for investors because they show that the portfolio may give higher returns relative to the level of risk. Whereas, a low Sharpe ratio (less than 1.0) is considered poor, meaning the portfolio is likely to produce low returns relative to the risk assumed.

How is the Sharpe ratio calculated? 

Now, let's look at how the Sharpe ratio is calculated. The Sharpe ratio can be calculated using the following formula:

Sharpe ratio = Rp - Rf / Sd 

where, Rp = Return on portfolio 

Rf = Risk-free rate of return 

Sd = Standard deviation of the portfolio

What is the Treynor Ratio?

The Treynor ratio in mutual funds, also known as the reward-to-volatility ratio, is a financial performance metric that helps investors determine how much extra return they are receiving for each unit of risk borne by an investment portfolio. Unlike the Sharpe ratio, which measures total risk, the Treynor ratio measures just systematic risk (risk that cannot be controlled) and is calculated using beta. 

A Treynor ratio greater than 0.5 is ideal for investors because it provides good returns for each unit of risk taken and demonstrates that the investment portfolio is efficiently managed. Whereas, a Treynor ratio close to 0 or negative, on the other hand, generally indicates low returns in relation to the level of risk taken.

How is the Treynor ratio calculated? 

The following is the formula for determining the Treynor ratio:

Treynor Ratio = (Rp - Rf) / ?p

Where:

• Rp = Return on the portfolio
  
  

• Rf = Risk-free rate
  
  

• ?p = Portfolio’s Beta (market risk)
  
  

Sharpe vs Treynor ratio: What's the real difference?

Treynor and Sharpe ratios are financial indicators of an investment portfolio's risk-adjusted performance. However, these ratios employ different methodologies to assess returns against risk. The following table illustrates some of the main differences between the Sharpe and Treynor ratios.  

Which ratio should investors trust more in Sharpe ratio vs Treynor ratio

Although the Treynor and Sharpe ratios use different methods to measure risk, both are important ratios for evaluating a portfolio's risk-adjusted performance. However, the choice of which ratio investors should trust more depends on the investor's situation.

On one hand, the Sharpe ratio measures the excess return over a risk-free investment by comparing it to total risk, which includes both systematic and unsystematic risk, which helps investors to compare and evaluate individual assets or portfolios that are not well-diversified. Standard deviation is used in this case to understand the risk factor.

On the other hand, the Treynor ratio determines excess return to market risk, or systematic risk. It is appropriate for a well-diversified portfolio in which unsystematic risk can be reduced.This ratio is helpful for investors looking to determine how effectively a portfolio's returns can compensate for market risk. Beta is used in this case to understand the risk factor.

Investors should consider both the ratios and other important metrics before making any investment decisions.

Which ratio performs better in volatile markets?

In a volatile market, the Sharpe ratio can perform better as compared to the Treynor ratio because the Sharpe ratio uses standard deviation to measure the extra returns of a portfolio by comparing it with total risk, which includes both systematic (market risk) and unsystematic (sector-specific risk) factors, which provides the overall risk-adjusted performance, whereas the Treynor ratio only focuses on systematic (market risk)  and assumes that other risks have been diversified, which may not be useful in a volatile market. It is up to the investor’s choice based on their investment criteria.

Common mistakes investors make when comparing Sharpe ratio vs Treynor ratio

Here are some common mistakes that investors make while comparing the Treynor and Sharpe ratios:

• Sharpe ratio measures risk for portfolios that are not well-diversified, and Treynor ratio is appropriate for well-diversified portfolios; however, if an investor uses Treynor ratio on an undiversified portfolio or Sharpe ratio on a diversified portfolio, it could lead to misleading interpretations of performance.
  

• Both Sharpe and Treynor ratios use historical data, which means both ratios use past data for measuring risk-adjusted performance, which may not be accurate when the market fluctuates in the future.  Performance of the investment portfolio changes over a period, and it doesn't stay consistent. 

• Investors assume that the Sharpe ratio can help to compare different asset classes and risk levels, but in reality, it helps in comparing similar investments. 

• Many investors assume that higher Sharpe and Treynor ratios automatically mean better investments. While these ratios do indicate high risk-adjusted performance, they don't reflect whether the underlying investment matches an investor’s risk tolerance. A high ratio may still come from volatile or high-risk strategies that aren't suitable for conservative investors.

Conclusion 

To conclude, both Sharpe and Treynor ratios are important tools for measuring portfolio performance, each providing a different approach, purpose, and valuable insights. We understood the meaning, respective formulas and the differences of Sharpe ratio vs Treynor ratio. Understanding their purpose, and choosing the right metrics can help investors make smarter investment decisions, which aligns with their financial goals and risk tolerance. 

FAQs

1. Which is better, the Treynor or the Sharpe ratio?

Deciding whether Sharpe or Treynor is better depends entirely on the investor's situation or the characteristics of the investment portfolio.

2. How do Treynor and alpha differ from Sharpe?

Treynor, Alpha, and Sharpe are used to measure the performance of an investment, but all three have different approaches. The Treynor ratio uses beta, the Alpha uses CAPM (capital asset pricing model), and the Sharpe ratio uses standard deviation to measure the risk.

3. Should the Treynor ratio be high or low?

A high Treynor ratio (greater than 0.5) is generally considered better, as it indicates higher returns for each unit of market risk.

4. What is the use of the Treynor ratio?

It helps investors to know how their portfolio generates extra returns, assuming market risk.