Jensen’s measure, popularly known as Jensen’s Alpha, was propounded by Michael Jensen in the year 1968. It is a metric to track the performance of mutual fund managers on a risk-adjusted basis. This model calculates the return on a portfolio in excess of its theoretical expected return and the excess return is attributable to the fund manager for his stock selection skill or timely buying of shares or both. Let us understand how investors can benefit while evaluating their portfolio or mutual funds.
What is Jensen’s Alpha
This model helps to monitor the performance of mutual fund managers on a risk-adjusted basis. It helps to understand whether an investment has performed better or worse than its beta value would suggest. It is derived from the capital asset pricing model (CAPM). Accordingly, beta indicates how closely an investment follows the upward and downward movements of the stock market indices. A beta of more than one means a stock or fund is more volatile than the market, which brings greater levels of risk in terms of losses or gains according to the movement of the indices.
Mechanics of Jensen’s Alpha
Let us assume that a portfolio or mutual fund realised a return of 17% last year. The approximate market index for this fund returned 12.5%. The beta of the fund versus the same index is 1.4 and the risk-free rate is 4%. Accordingly, Jensen’s Alpha = 17 – [4 + 1.4 *(12.5-4)] = 17 – [4 + 1.4* 8.5] = 17 – [4 + 11.9] = 1.1%.
So, with the given beta of 1.4, the fund is expected to be riskier than the market index and thus earn more. A positive alpha is an indication the portfolio manager earned a substantial and superior return to be compensated for the additional risk taken during last year. If the fund would have returned 15%, the computed alpha would be -0.9%. A negative alpha indicates the investor was not earning enough returns for the quantum of risk which was assumed by him.
Look at Jensen’s Alpha while investing
Every investor should understand the associated risks when he invests in a particular asset. For that, he needs a properly calculated measure of the total return of an investment against the risk involved in it. The aim of investors is always to go for securities that offer maximum returns with minimal risks. This means that between two mutual fund schemes which are offering similar returns, the one with less risk would be more lucrative for investors than the one with higher risk.
The Jensen’s Alpha could help investors to determine if the return an asset is generating on average is acceptable compared to the risks it is offering, which is commonly known as risk-adjusted return. Therefore, alpha represents how much of the rate of return on the portfolio is attributable to the manager’s ability to derive above-average returns adjusted for risk.
Superior risk-adjusted returns indicate that the manager is good at either predicting market turns, or selecting under-valued shares or both.
To conclude, while investors consider the risk-adjusted returns of an asset they should use alpha along with beta. Alpha measures the excess return of a fund or portfolio whereas beta reflects how volatile the fund or portfolio is compared to the market.
The writer is a professor of finance & accounting, IIM Tiruchirappalli
APLHA & Beta
Jensen’s Alpha helps to monitor the performance of mutual fund managers on a risk-adjusted basis
Superior risk-adjusted returns indicate the manager is good at either predicting market turns, or selecting under-valued shares or both
While investors consider the risk-adjusted returns of an asset they should use alpha along with beta. Alpha measures the excess return of a fund or portfolio whereas beta reflects how volatile the fund or portfolio is compared to the market