What is Jensen's Alpha?
Jensen's Alpha, or just "Alpha", is used to measure the risk-adjusted performance of aor in relation to the expected market return (which is based on the capital asset pricing model (CAPM).
The higher the alpha, the more a portfolio has earned above the level predicted.
The measure was first used by Michael Jensen in 1968 and was originally designed to evaluate fund managers, i.e. to gauge if it was possible for them to consistently outperform the. Jenson's results, however, suggested that this is rarely the case.
Jensen's Alpha is also known as "Jensen's Performance Index" and "Jensen's Measure".
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Why is Jensen's Alpha useful to investors?
Jensen's Alpha is important tobecause they need to look not only at the total return of a security or portfolio, but also at the amount of involved in achieving that return.
Usually, investors will aim to achieve a high return with a minimum amount of risk. So if, for example, two portfolios yielded identical returns, but one involved lower risk, the one with lower risk would rationally be the more attractive option.
Jensen's Alpha can help determine if the average return generated is acceptable based on the amount of risk involved. If the return is higher than that predicted by the CAPM, the security or portfolio is said to have a positive alpha (or an abnormal return).
Investors are always looking for opportunities where a positive alpha is involved.
The formula for Jensen's Alpha
Jensen's Alpha is calculated using the following equation:
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