Developed by Michael Jensen in the 1960s, this metric is a popular tool for evaluating the skill of portfolio managers.
Calculation & Formula of Jensen’s Alpha
The formula for Jensen’s Alpha is:
- Portfolio Return (Rp): This is the actual return of the portfolio over a specified period.
- Risk-Free Rate (Rf): Typically, the yield on government bonds is used as the risk-free rate.
- Beta (β): Represents the sensitivity of the portfolio’s returns to the returns of the market.
- Market Return (Rm): The return of the market benchmark, such as the S&P 500.
Jensen’s Alpha is used to measure how much of the portfolio’s performance can be attributed to the manager’s decision-making, as opposed to the general market movement.
A positive Alpha indicates that the portfolio has outperformed its benchmark, suggesting the manager’s skill.
A negative Alpha suggests underperformance.
It is often used to assess the ability of fund managers to generate excess returns, adjusted for market risk.
Jensen’s Alpha provides a risk-adjusted measure of performance, considering both the market risk and the return aspect.
It allows for direct comparison of a portfolio’s performance against its benchmark.
This makes it easier to evaluate investment or trading skill.
Jensen’s Alpha is based on the CAPM, which has its own set of assumptions and limitations, such as the notion of a single-factor model (market risk).
Market Index Selection
The choice of market index can greatly influence the Alpha calculation.
An inappropriate benchmark can lead to misleading results.
Alpha is a backward-looking measure, relying on historical data.
So, it may not necessarily predict future performance.
Jensen’s Alpha measures a portfolio manager’s ability to generate excess returns above those predicted by the market’s overall performance.
Its effectiveness in isolating the manager’s contribution from general market helps with evaluating investment skill and portfolio performance.
Nevertheless, its reliance on historical data and the CAPM framework necessitates a careful interpretation.