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What Is Jensen’s Alpha

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Geetanjali Lachke

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Learn how Jensen’s Alpha measures a portfolio’s excess return relative to the expected return predicted by Capital Asset Pricing Model (CAPM).

Jensen’s Alpha is a financial performance measure used to evaluate how well an investment or portfolio performs relative to its expected return based on market risk. It was developed by economist Michael Jensen and is widely used in portfolio analysis. Jensen’s Alpha helps investors understand whether a portfolio manager has generated returns above or below what would be expected given the portfolio’s exposure to market movements.

Introduction to Jensen’s Alpha

Jensen’s Alpha measures the excess return of a portfolio over its theoretical expected return. This expected return is calculated using the Capital Asset Pricing Model (CAPM). The metric adjusts performance for systematic risk, making it useful for comparing portfolios with different risk levels. A positive Jensen’s Alpha indicates superior risk-adjusted performance, while a negative value suggests underperformance relative to the market benchmark.

Understanding the Concept of Alpha

In investing, alpha refers to the excess return generated by an investment compared to a benchmark index. It represents the portion of returns attributed to skill, strategy, or decision-making rather than general market movements. Alpha can be positive or negative. While basic alpha looks at absolute excess returns, it does not always adjust for risk. Jensen’s Alpha refines this concept by explicitly accounting for market risk.

Jensen’s Alpha vs Alpha

Alpha and Jensen’s Alpha are related but not identical. Traditional alpha measures excess returns without formally adjusting for systematic risk. Jensen’s Alpha, on the other hand, incorporates beta and the risk-free rate using the CAPM framework. This makes Jensen’s Alpha a more precise measure of risk-adjusted performance. In simple terms, alpha shows outperformance, while Jensen’s Alpha explains whether that outperformance is justified given

Jensen’s Alpha Formula

Jensen’s Alpha is calculated using the following formula:

  • Jensen’s Alpha = Actual Portfolio Return − Expected Portfolio Return

Where expected return is calculated using CAPM:

  • Expected Return = Risk-Free Rate + Beta × (Market Return − Risk-Free Rate)

Each component reflects risk, market performance, and portfolio sensitivity.

How to Calculate Jensen’s Alpha

Jensen’s Alpha measures a portfolio’s risk-adjusted performance relative to a benchmark. The calculation involves:

  • Determine Actual Portfolio Return: Identify the return generated by the portfolio over the chosen period.

  • Identify Risk-Free Rate: Use the return on government securities or equivalent low-risk instruments.

  • Calculate Portfolio Beta: Measure the portfolio’s sensitivity to market movements.

  • Find Market Return: Use the return of the benchmark index over the same period.

  • Apply CAPM Formula: Compute the expected return using CAPM and subtract it from the actual return to obtain Jensen’s Alpha.

Example Calculation of Jensen’s Alpha

Consider the following example calculation:

  • Portfolio Return: 14%

  • Risk-Free Rate: 4%

  • Market Return: 10%

  • Portfolio Beta: 1.2

  • Expected Return (CAPM): 4 + 1.2 × (10 − 4) = 11.2%

  • Jensen’s Alpha: 14 − 11.2 = 2.8%
    A positive alpha of 2.8% indicates the portfolio outperformed its risk-adjusted expected return.

When to Use Jensen’s Alpha

Jensen’s Alpha is a useful metric in the following scenarios:

  • Comparing Portfolio Managers and Funds: It helps evaluate mutual funds, portfolio managers, or investment strategies against similar market benchmarks to determine relative performance.

  • Assessing Actively Managed Portfolios: Particularly effective for portfolios where risk-adjusted returns matter, helping investors understand performance beyond raw returns.

  • Evaluating Manager Skill vs Market Exposure: Indicates whether a portfolio’s returns result from managerial skill rather than simply higher exposure to market risk.

  • Long-Term Performance Analysis: Offers insight into consistent performance over multiple periods, rather than short-term market fluctuations.

Advantages of Jensen’s Alpha

The benefits of using Jensen’s Alpha include:

  • Adjusts for Market Risk: Provides a risk-adjusted measure, allowing fair comparison across different portfolios.

  • Highlights Manager Skill Objectively: Identifies whether active management adds value beyond market movements.

  • Based on a Widely Accepted Model: Grounded in the Capital Asset Pricing Model (CAPM), offering credibility and standardisation.

  • Supports Long-Term Evaluation: Useful for assessing performance trends over extended periods rather than focusing on short-term returns.

  • Comparative Benchmarking: Enables systematic comparison between portfolios and market indices.

Limitations of Jensen’s Alpha

Investors should consider the following constraints:

  • Dependent on CAPM Assumptions: Accuracy is tied to assumptions like linear risk-return relationships, which may not always hold.

  • Beta Sensitivity: Portfolio beta can fluctuate over time, impacting the reliability of calculated alpha.

  • Benchmark Selection Matters: Results can vary significantly depending on the chosen market benchmark.

  • Excludes Unsystematic Risk: Does not capture company-specific or sector-specific risks.

  • Not Standalone: Should be used alongside other metrics such as Sharpe Ratio or Treynor Ratio for a complete performance evaluation.

Jensen’s Alpha in Portfolio Performance

Jensen’s Alpha is commonly used to evaluate portfolio managers. A consistently positive alpha suggests effective investment decisions after adjusting for risk. Negative values may indicate inefficient strategies. By focusing on risk-adjusted returns, Jensen’s Alpha helps investors make more informed performance comparisons across portfolios.

Conclusion & Key Takeaways

Jensen’s Alpha is an important metric for measuring risk-adjusted investment performance. It improves upon traditional alpha by incorporating market risk and expected returns. While it has limitations, it remains an important tool for evaluating portfolio managers and investment strategies when used with complementary measures.

Disclaimer

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.

FAQs

What does Jensen’s Alpha measure?

Jensen’s Alpha measures the excess return of a portfolio compared to the expected return based on its risk relative to the market. It shows whether a portfolio has outperformed or underperformed given its level of market risk.

Jensen’s Alpha differs from regular alpha because it adjusts returns using the Capital Asset Pricing Model (CAPM). Regular alpha may indicate performance without accounting for market risk, whereas Jensen’s Alpha factors in portfolio sensitivity to market movements.

The formula for Jensen’s Alpha is: Actual Portfolio Return − [Risk-Free Rate + Beta × (Market Return − Risk-Free Rate)]. It calculates performance relative to market expectations and risk exposure.

Yes, a negative Jensen’s Alpha indicates the portfolio underperformed relative to its expected return based on market risk. It suggests the portfolio generated lower returns than what its risk profile would justify.

Calculating Jensen’s Alpha requires the portfolio return, portfolio beta, market return, and risk-free rate. These inputs help determine expected returns and assess performance adjusted for market risk.

Jensen’s Alpha is used to evaluate the performance of portfolios and funds. It helps investors and fund managers understand if returns are above or below expectations given the portfolio’s market exposure.

Jensen’s Alpha is most suitable for diversified, market-linked portfolios. It may be less relevant for concentrated, non-market-correlated, or highly illiquid portfolios where market risk adjustments do not accurately reflect performance.

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Hi! I’m Geetanjali Lachke
Financial Content Specialist

Geetanjali is an emerging content writer with a passion for writing and marketing. She focuses on crafting clear, engaging blog posts and articles that simplify complex topics, particularly in finance and business. Geetanjali is dedicated to delivering insightful content that helps readers understand and navigate critical concepts, empowering them to make informed decisions and stay ahead in the ever-evolving landscape of finance and business.

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