Treynor Ratio

The Treynor ratio, developed by economist Jack Treynor, is similar to the Sharpe ratio, but it uses beta rather than total volatility as the measure of risk. Beta captures only systematic risk, the risk that cannot be removed by diversification.

It is calculated by subtracting the risk-free rate from the investment's return and dividing by its beta. For example, a fund returning 10% with a risk-free rate of 3% and a beta of 1.2 has a Treynor ratio of about 5.8%.

The Treynor ratio is most suitable for evaluating investments that form part of a well-diversified portfolio, where unsystematic risk has largely been diversified away and only market risk matters.

For a concentrated portfolio, the Treynor ratio can be misleading, because it ignores risks specific to individual holdings. In those cases, the Sharpe ratio, which uses total volatility, gives a fuller picture. Results also depend on how beta is estimated and over what period.