Question

Define the Sharpe, Treynor, Jensen, and Information measures. In short, what do they all seek to measure? Which one is best? How should these measures be best employed in a portfolio analysis?

Answer 1

Sharpe Ratio

Sharpe ratio comes very handily to measure the risk-adjusted returns potential of a mutual fund. Generally, risk-adjusted return happens to be the returns earned over and above the returns generated by a risk-free asset like a fixed deposit or a government bond. The excessive returns are viewed in the light of the “extra risk” which an investor takes upon investing in a risky asset like equity funds. The risk inherent in an investment is determined using the standard deviation. Thus, a higher Sharpe ratio indicates better return yielding capacity of a fund for every additional unit of risk taken by it. It becomes a justification for the underlying volatility of the fund. In fact, you may use the Sharpe ratio to compare the funds.

Treynor Ratio

The Treynor ratio, also known as the reward-to-volatility ratio, is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio.Excess return in this sense refers to the return earned above the return that could have been earned in a risk-free investment. Although there is no true risk-free investment, treasury bills are often used to represent the risk-free return in the Treynor ratio.Risk in the Treynor ratio refers to systematic risk as measured by a portfolio's beta. Beta measures the tendency of a portfolio's return to change in response to changes in return for the overall market.

Jensen ratio

The Jensen's measure is a risk-adjusted performance measure that represents the average return on a portfolio or investment, above or below that predicted by the capital asset pricing model (CAPM), given the portfolio's or investment's beta and the average market return. This metric is also commonly referred to as simply alpha.To accurately analyze the performance of an investment manager, an investor must look not only at the overall return of a portfolio but also at the risk of that portfolio to see if the investment's return compensates for the risk it takes.

Information Ratio

“Information ratio” (IR) refers to the measure of an active investment manager’s success strategy which is derived by comparing the excess returns generated by the investment portfolio to the volatility of those excess returns.The formula for information ratio is derived by dividing the excess rate of return of the portfolio over and above the benchmark rate of return by the standard deviation of the excess return with respect to the same benchmark rate of return.

The Treynor, Sharpe, and Jensen ratios combine risk and return performance into a single value, but each is slightly different. Which one is best Perhaps, a combination of all three give us the best result.