Question

Compare and contrast the Sharpe ratio, the Treynor ratio and the Information Ratio. Why don’t we pick the one ratio deemed to be the best of the three and use it exclusively? What does each ratio inform us?

Answer 1

The Sharpe ratio helps in understanding the risk-adjusted performance by dividing the excess market returns by the standard deviation of the portfolio.

The Treynor ratio is a similar metric that assesses the excess market returns of the portfolio. However, it uses the beta in the denominator instead of the standard deviation so as to account only for market risk instead of total risk as is the case in Sharpe Ratio.

The Information Ratio compares the excess return (beyond a pre-specified benchmark) as against the volatility of those returns. This assesses whether and by how much the portfolio yielded returns that were superior to a benchmark.

Each of the three ratios focuses on assessment of different factors even though treynor and Sharpe ratio bear resemblance as they use the excess market returns in the numerator. The Sharpe ratio informs us of the reward in return for risk whereas the Treynor ratio gives us an idea of the reward as a function of volatility. The Information Ratio is indicative of the investor's prowess and consistency in beating the benchmark. Hence, each of these three ratios assess different facets of the same core subject and as such are individually and collectively used to assess the historical returns of a fund scheme.